Custodial vs Non-Custodial Wallets
- The concept “Not your keys, not your wallet’’ became popular following the infamous Mt.Gox hack that occurred in 2013. While the exchange handled over 70% of all bitcoin transactions at the time, hackers stole over 740,000 bitcoin from customers and 100,000 from the exchange. This infamous attack forms a major base upon which custodial and non-custodial wallets are often compared.
- With the global cryptocurrency user base standing at over 320 million, trading keeps raging. As such, cryptocurrency users are often on the lookout for wallets that have the best features.
- Diverse wallets exist. But what differentiates them is whether the users take custody of their private keys that are needed to sign transactions.
- While a concerned entity or company holds the private keys of custodial wallets, non-custodial wallet users take total control of their private keys.
What is a Custodial Wallet?
Custodial wallets, just as the name suggests, are wallets where users’ private keys are controlled by companies who run the wallet service. In simple terms, the user entrusts private keys into the hands of a third party, giving them the sole right to sign cryptocurrency transactions.
Custodial wallets are controlled by centralized projects, which show several similarities with traditional banks. These similarities include complying with financial rules and regulations set by a country or state to prevent fraud, money laundering, and terrorism financing. As such, users of such wallets must conform to verification standards by providing their real names, valid means of identification, and proof of address.
Investors have several reasons for choosing custodial wallets. First is the abundance of liquidity that facilitates conversion from one crypto to another or crypto to fiat. Second is the security it provides, especially to those who find it difficult to store seed phrases and private keys properly. The third is the fact that most custodial wallets reward investors for saving coins, and buying and selling digital assets is quite easy.
What are Non-Custodial Wallets?
Non-custodial wallets are blockchain wallets that entrust private keys to the user. These wallets give users total custody and control of their funds, allowing them to send and receive digital assets as they deem fit.
The majority of non-custodial wallets are decentralized to further align the ultimate goal of crypto creation – decentralization and “democratization” of finance. As such, users are not under any obligation to prove their identity. Non-custodial wallets rarely comply with financial laws.
Upon signing up on a non-custodial wallet, users are provided with a 12-24 mnemonic phrase that can serve as a backup when a device is stolen or to maintain the same wallet on different interfaces, such as desktop and mobile. A major limitation with the non-custodial wallet is that once seed phrases are lost, they can never be recovered, leading to the permanent loss of funds.
The Lighting Network has constantly made waves. Hence, crypto users can access this and more features with non-custodial wallets.
Custodial vs Non-Custodial Wallets: Highlighting the Difference Between Them
Both custodial and non-custodial wallets have a major similarity in storing digital currencies and non-fungible tokens. However, there are several factors that form the basis upon which they are differentiated. Some of these factors include private key custody, transaction type, recovery possibility, security, offline or online usage, and future scope.
Private key custody
Private key custody is one of the major factors that come to mind when exploring the differences between custodial and non-custodial wallets. Unlike the public key, which is essentially your crypto wallet address similar to a public-facing address, your private key is what unlocks a wallet to not only prove ownership of the coins but also facilitate the outward movement of cryptocurrency from the wallet. For instance, the exterior of a car is the public key, but the key that actually opens the car to unveil the interior is the private key.
With custodial wallets, a third party is directly involved in managing the private keys of the wallet, giving them the ultimate power to approve cryptocurrency transactions. Third parties, in this case, could be the wallet service providers or other platforms the wallet providers collaborate with.
But with a non-custodial wallet, users have the sole right of retaining absolute control over their wallets. In simple terms, users are able to view transaction details on the blockchain since they have total control of their private keys. Non-custodial wallets work on the premise upon which bitcoin was created, giving users the opportunity to be their own banks without third-party interference. This explains why non-custodial wallets are also called self-custodial wallets.
Transactions in custodial and non-custodial wallets differ as they could be on the chain or off-chain.
When transacting in custodial wallets, you should know that such transactions do not happen directly on the blockchain. However, it occurs off-chain as transactions do not reflect on the blockchain in real time.
For instance, if an investor chooses to swap some Satoshis for Ethereum using a custodial wallet, that transaction would not be found on the blockchain, but the wallet provider updates the database, which indicates the value of digital assets now owned by the investor.
In the case of non-custodial wallets, transactions do not occur internally but on the blockchain. This means the transactions done by such users are recorded on the blockchain, displaying even the smallest details.
Transaction speed and cost
Transaction speed and cost have remained major issues in the blockchain ecosystem. In fact, investors prefer to use cryptocurrency exchanges because the speed and cost of transactions are more fair compared to traditional financial institutions.
While it will be agreed that blockchain transaction speed and cost are fair, there are still discrepancies in speed and cost when comparing custodial and non-custodial wallets.
When an investor transacts with a custodial wallet, the transaction is often delayed because the wallet provider must approve the transaction, and the transaction history is not recorded on the underlying blockchain. Another issue with custodial wallets is the presence of custodians and intermediaries that facilitate transactions. These intermediaries charge particular fees that result in higher costs of transactions.
With non-custodial wallets, transactions can be initiated directly on the underlying blockchain without the presence of intermediaries who are mostly after commissions. While the absence of third parties prompts lower transaction costs, the details also appear on the blockchain in real time.
Security is a major criterion that distinguishes custodial and non-custodial wallets. It is important to understand that private key custody influences the security of a wallet to a great extent.
Custodial wallet providers often store users’ private keys in centralized servers, which are often prone to security breaches that may result in the loss of large sums of money. An instance that exposes the vulnerability of custodial wallets is the Liquid exchange security breach where over $90 million was stolen.
With non-custodial wallets, users have total control of their private keys, making it difficult for their funds to be stolen. This goes to show how non-custodial wallets are secure. However, if users carelessly store their private keys, a security breach is likely to occur should an external party get hold of it.
Backing up and recovering funds
Humans can never be careful enough, but what happens when investors lose access to their wallets?
Investors who store their funds in custodial wallets often rely on the wallet providers to retrieve their funds should their sign-in code go missing. As such, custodial wallets have a customer support team that can attend to this.
With non-custodial wallet users, the case is the direct opposite. Upon signing up to use the wallet service, investors are provided with a seed phrase which should be written on a piece of paper and stored securely where no one else gets to see it. Should this mnemonic phrase go missing, it means such an investor will lose access to all assets stored in the wallet. Non-Custodial wallets do not have a support team to attend to issues of missing private keys.
Regulatory compliance is now a rising issue in cryptocurrency as countries are now implementing laws to protect investors. It is expected that wallets and exchanges comply with them.
When investors sign up to use a custodial wallet service, they are obliged to complete some know-your-customer (KYC) and Anti-Money-Laundering (AML) forms, ensuring that they meet security and regulatory standards. This makes the onboarding process quite stressful, and transactions are not anonymous.
With non-custodial wallets, investors do not need to complete KYC and AML forms. They just need to sign up and create a 4-6 digit password. This makes the onboarding process easy while investors’ transactions are completely anonymous.
Online or offline accessibility
Custodial wallets are mainly hot or cold wallets that require connections to the internet to meet centralized servers and access blockchain data that are needed to complete transactions. This feature is what makes custodial wallets extremely vulnerable to cyber criminals.
With non-custodial wallets, there is so much flexibility. They can function both offline and online. Non-custodial wallets can be accessed through a web browser or mobile application. Another category of non-custodial wallets is hardware wallets which can basically sign transactions offline. Because they protect private keys from cyber hackers, they are considered the safest wallets.
Liquidity availability is a fundamental part of the crypto market as it determines the manner in which digital assets are converted from one coin to another or even fiat.
Custodial wallets are one of those considered to have sufficient liquidity. This is because the providers often collaborate with a number of third-party services whose major aim is to provide liquidity and earn commissions.
On the other hand, non-custodial wallets do not have sufficient liquidity as decentralized services hardly collaborate with intermediaries. These wallets only rely on the liquidity that investors contribute to the liquidity pools.
One of the notable trends in the cryptocurrency industry is censorship which has affected how investors in particular areas trade.
Custodial wallets are highly susceptible to censorship because they are controlled by centralized authorities. For instance, in war-torn Ukraine, investors in particular areas are not permitted to trade using centralized wallets. The same happened to investors linked to recent truck drivers’ protests in Canada as the government attempted to censor their accounts.
This issue does not exist in non-custodial wallets due to the absence of third-party institutions that may not want to complete transactions. The transactions are censorship-resistant, given that investors take custody of their private keys.
While custodial wallet users do not worry about losing their passwords, losing private keys is an expensive mistake non-custodial wallet users should avoid. Should this happen, funds will be lost forever.
Types of Custodial and Non-Custodial Wallets
Types of custodial wallets
Custodial wallets are mainly internet-based wallets that are controlled by centralized authorities. The majority of them exist as web applications and mobile applications such that investors can use them via a desktop or smartphone device.
Popular examples are Coinbase, Binance, Robinhood, Free wallet, Bitstamp, Bitbuy, and many others. Transactions can only be completed after verification.
Types of non-custodial wallets.
Non-custodial wallets are often controlled by investors as they retain sole custody of the private keys. These wallets can work either online or offline and include:
- Hardware wallets
- Browser wallets
- Mobile wallets
Also regarded as cold wallets, Hardware wallets are physical devices that store private keys. These wallets have the same look as a flash drive and must be plugged into a personal computer or mobile device to access the wallet and conduct transactions. Because they do not need an internet connection to function, they are regarded as the safest wallets in existence. Examples include Ledger, Trezor, Nano-X, and keepKey.
Browser wallets typically exist as an extension that can be added to an investor’s browser. These wallets store private keys in the browser for easy completion of transactions and connection to decentralized applications (DApps). An example is MetaMask. Other browser wallets can be built directly into the browser. An example is Brave.
Mobile wallets are applications that are downloaded and installed on smartphones. These wallets securely store private keys, allow investors to view them at any time, and enable easy transactions through a friendly user interface. Examples of non-custodial wallets that exist as mobile applications include Trust Wallet and MetaMask.
Benefits and Limitations of Custodial Wallets
Custodial wallets, though controlled by central authorities, have some benefits and limitations which will be outlined below.
Benefits of custodial wallets
- Complete access to funds: With custodial wallets, investors can maintain complete access to their funds even though they do not control the private keys.
- Better option in the absence of security: For investors who have issues with computer security, using custodial wallets will be a better option. This way, external parties would not have access to private keys that comes with non-custodial wallets.
- Reward on savings: Some custodial wallets usually reward investors based on the number of coins held in the wallet. This act is believed to drive user retention.
- Sufficient liquidity: Due to the presence of third parties that provide liquidity, custodial wallets are often used by investors who want to swap coins or convert coins to cash.
Limitations of custodial wallets
- Non-custody of private keys: Since investors do not have access to private keys, security remains in the hands of an external party, causing investors to lose funds should a hack occur.
- Funds are entrusted to a third party: since investors do not hold private keys, funds are left with external parties who may decide to steal them.
- Centralization: Custodial wallets operate similarly to traditional banks which often results in censorship.
- Absence of vast coins: Investors hardly gain access to new coins, especially those created via forks of coins.
Benefits and Limitations of Non-Custodial Wallets
Benefits of non-custodial wallets
- Private key ownership: Investors who use non-custodial wallets have complete access to their private keys, making security their major responsibility.
- Non-censorship issues: Since non-custodial wallets are completely decentralized, transactions are anonymous without censorship concerns.
- Vast cryptocurrencies and advanced features: Decentralized wallets have a vast array of cryptocurrencies, including those developed through forks of other digital assets. In addition, these wallets have diverse features such as liquidity pools, DApps, NFTs, etc.
- Higher security levels: The combination of hardware and paper wallets gives investors a higher level of security. This is in addition to several other security levels that are unlocked based on the model of the wallet.
- Swift onboarding: Because KYC and AML forms are not associated with non-custodial wallets, sign-ups are usually completed in a short time.
Limitations of Non-Custodial Wallets.
- Insufficient liquidity: With liquidity insufficiency that comes with non-custodial wallets, converting coins is often difficult, hence, the need to involve other decentralized exchanges.
- Since security remains an investor’s responsibility, it comes with great risks as funds could be lost permanently should investors lose their private keys.
- Difficult interface: Non-custodial wallets often have difficult user interfaces that make trading complicated for new investors.
Custodial or Non-Custodial, Which Wallet is the Right Fit for Investors?
Making a choice between custodial or non-custodial wallets solely depends on what an investor needs. If an investor is not good at managing non-custodial wallets on PCs and browsers or is just about short-term investment and instant trading, then a custodial wallet will be an appropriate choice.
If an investor has a deep interest in cryptocurrencies and wants to interact with new coins and NFTs and makes use of decentralized applications, the investor will be better off with a non-custodial wallet. This will allow an investor to interact with the “permissionless” cryptocurrency ecosystem.
Generally, it is important that investors mark out the desired features they need in a wallet before storing their coins. The most important thing to do is research.
Frequently Asked Questions (FAQs)
Is Coinbase a custodial or non-custodial wallet?
Coinbase is a custodial wallet that is powered by the largest cryptocurrency wallet in the United States. To use the wallet, investors must provide their real names and valid means of identification.
Is Trust Wallet a custodial or non-custodial wallet?
Trust Wallet is a non-custodial wallet. Users are usually not obliged to fill in KYC and AML forms. It is one of the largest mobile application non-custodial wallets.
Is Binance a non-custodial wallet?
Binance wallet is a custodial wallet powered by the largest cryptocurrency wallet.