Non-custodial and custody wallets: what’s the difference?

In short

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

The spectacular repercussions of the FTX cryptocurrency exchange sent shockwaves across the industry. It also highlighted several important issues, including the very nature of speculative investing.

Shortly before filing for bankruptcy, FTX suspended withdrawals of users’ funds, citing liquidity problems and leaving the army of angry customers without access to their hard-earned coins.

The truth is that this could happen to pretty much any other centralized cryptocurrency exchange if it were in a liquidity crisis like FTX, as the vast majority of them use so-called unsecured wallets, meaning it is the exchange that holds the funds. customers, not customers themselves.

This Learn article will look at what crypto wallets are and what the difference is between non-custodial 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 the user’s device (desktop or mobile). Both hardware and software wallets store private keys, strings of letters and numbers that act, in effect, like a highly sensitive password.

Access to a private key gives an individual the ability to send cryptographic resources from a particular public address, making private key management of the utmost importance.

Custody wallets versus non-custodial wallets

Custody wallets are considered a low-entry barrier for those new to the crypto space since they are easy to use and are accessible from any device with an internet connection. However, security is a major concern.

With custody wallets, private keys are held by a third party, such as a cryptocurrency exchange or wallet provider, which means users don’t really control their crypto assets. Instead, users need to trust that the third-party custodian will protect their cryptocurrencies for them.

Although some providers offer insurance for the cryptocurrency they store, custodial wallets have in the past caused massive Bitcoin losses due to mismanagement and / or neglect of protecting users’ funds.

Contrary to this, non-custody wallets (also known as automatic custody wallets) are designed to give users full control over their private key; however, with the freedom to be your own bankers comes the sole responsibility to protect your holdings.

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

Some non-custodial wallets come as software you install on your computer or mobile device and include the likes of Bitpay, Electrum, Trust Wallet, and MetaMask.

What are crypto wallets used for?

Once a wallet is installed on a device, you can buy, sell and store Bitcoin or other supported cryptocurrencies; or carry out any 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 cryptocurrencies through built-in cryptocurrency exchanges via a dedicated card, while others will require you to deposit funds on a trading platform first.

Normally, you simply need to know the receiving address if you wish to send funds or provide your own address to receive a transaction. Many wallets simplify this process with the help of QR codes, allowing you to send or receive crypto assets quickly and securely.

More 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 you interact with cryptocurrencies such as Bitcoin, the transactions are pseudonymous, i.e. they can be seen on the public blockchain. But there is no direct way to associate an address with a particular individual.

In other words, wallet interfaces allow users to interact with their digital assets so they can send peer to peer transfers over the network without the need for trusted intermediaries or without 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 funds.

In theory, self-custody crypto wallets are mostly secure: coins with a simple public address cannot be stolen, nor can network transactions be compromised by third parties. Also, as we saw with the FTX case, non-custodial wallets can be an obvious choice for anyone looking to be financially sovereign.

However, your funds are only as secure as the private key required to access and send the coins. When interacting with cryptocurrencies, there is no central authority to appeal to if you lose your funds, so it is most likely gone forever.

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