Non-Custodial vs Custodial Wallets: What’s the Difference? – Decrypt

The spectacular the outcome of the FTX encryption exchange sent shockwaves through the industry. It also highlighted several important issues, including the very nature of speculative investment.

Shortly before filing for bankruptcy, FTX suspended withdrawals of user funds, citing liquidity issues – leaving the army of angry customers without access to their hard-earned coins.

The truth is that this could happen to virtually any other centralized crypto exchange if it were to run into a liquidity crisis like FTX, since the vast majority of them use so-called non-custodial wallets, meaning that it is the exchange that holds the customers’ money. , not the clients themselves.

This Learn article will look at what crypto wallets are and what the difference is between non-custodial wallets and custodial wallets.

What is a crypto wallet?

A crypto wallet is a piece of software or hardware that allows you to store, access and interact with cryptocurrencies such as Bitcoin and Ethereum.

While hardware wallets are a standalone physical device used to store digital assets, software wallets are installed on a user’s device (computer or mobile). Both hardware and software wallets store the private keys – strings of letters and numbers that in effect act as a highly sensitive password.

Access to a private key allows an individual to send crypto assets from a particular public address, making private key management of utmost importance.

Custodial wallets vs non-custodial wallets

Custodial wallets are considered a low barrier to entry for those new to the crypto space because they are easy to use and can be accessed from any device with an internet connection. However, security is a big problem.

With escrow wallets, private keys are held by a third party, e.g. a crypto exchange or a wallet provider, meaning that users are not really in control of their crypto holdings. Instead, users must trust that the third-party custodian will secure their crypto for them.

While some providers offer insurance for cryptocurrency they store, escrow wallets have caused large Bitcoin losses in the past due to mismanagement and/or negligence in securing users’ funds.

In contrast, non-custodial wallets (also known as self-maintaining wallets) are designed to give users full control over their private key; But with the freedom to be one’s own bankers also comes sole responsibility for protecting one’s holdings.

One of the most popular types of non-custodial wallets are hardware, or “cold” wallets, which store private keys offline on a standalone device, often similar in look and feel to a USB drive. Hardware wallets only access the internet when you want to send a cryptocurrency transaction.

Some escrow wallets come as software that you install on your computer or mobile device and include bitpay, Electrum, Trust Wallet and MetaMask.

What are crypto wallets used for?

Once you have a wallet installed on a device, you can buy, sell and store Bitcoin or other supported cryptocurrencies; or make other transactions, such as paying for goods and services; or get paid for your work.

Some wallets have a built-in option that allows you to buy and sell crypto through integrated crypto exchanges via a dedicated tab while others will require you to first deposit funds into a trading platform.

Normally, you simply need to know the recipient address to send money, or enter your own address to receive a transaction. Many wallets make this process easier with the help of QR codes, allowing you to send or receive crypto assets quickly and securely.

Greater privacy

A key difference between a user’s crypto wallet and a bank account in the traditional banking system is that traditional bank account numbers are directly linked to an individual’s identity, allowing financial institutions and government agencies to track transactions.

When interacting with cryptocurrencies like Bitcoin, transactions are pseudonymous, meaning they can be viewed on the public blockchain. But there is no direct way to link an address to a particular individual.

In other words, wallet interfaces allow users to interact with their digital assets in a way that allows them to send peer-to-peer transfers on the network without the need for trusted intermediaries or compromising their privacy.

Security aspects

There are pros and cons to keeping your crypto assets in different types of wallets, so it’s up to you to decide the right mix of convenience and security for your money.

In theory, self-maintaining cryptowallets are mostly secure: it is neither possible to steal coins with just a public address, nor can the network’s transactions be compromised by a third party. Also, as we saw with the FTX case, wallets without storage can be an obvious choice for anyone who wants to be financially sovereign.

Still, your money is only as safe as the private key required to access and send the coins. When you interact with crypto, there is no central authority to appeal to if you lose your money, so it’s most likely gone forever.