Understanding Custodial vs. Non-Custodial Crypto Wallets

How do you store cryptocurrency? It’s digital. It has no physical form. But how come people are able to store them inside of “wallets”? If that makes no sense to you, don’t worry — read on.

When talking about how to store crypto assets, the topic of custodial vs non-custodial crypto wallets often comes up in discussion.

Here’s a short guide on crypto storage. After reading, you should be able to decide which type of wallet (custodial or non-custodial wallet) is best for you.

What is a Custodial Wallet?

A custodial wallet is like a bank account. When you use a custodial wallet, you are essentially entrusting your cryptocurrency to a third party, such as a crypto exchange or a wallet service provider.

This third party holds your private keys – the cryptographic codes that control access to your crypto assets – and manages the security of your funds on your behalf.

Example:

Imagine you have some gold coins and you decide to store them in a bank’s safe deposit box. The bank keeps your coins safe, and you trust the bank to ensure they remain secure. Similarly, with a custodial wallet, you rely on the service provider to protect your digital assets.

What is a custodian?

When you buy gold online, you most likely won’t see that shiny gold bar mailed to your doorstep. Instead, the agency that sold you gold, stores the gold for you (or asked someone else to do it on their behalf), and you receive a receipt that you can later present as proof that you owned an amount of gold.

This agency is a custodian, because it stores your assets on your behalf. A custodial agreement is that relationship you have with the agency — you present a proof of identity in order to have access to your gold bars.

Can a third party store my crypto?

These days, it’s so easy to buy and hold crypto. All you have to do is sign up to an exchange, verify your identity, buy crypto with cash, and essentially “own” a certain amount of crypto.

In this model, the crypto exchange that you’re buying from acts as a custodian. In other words, the crypto wallet that you are using with the exchange is a custodial wallet — your crypto assets are stored by a third party on your behalf.

When you log into your account of that crypto exchange, you are providing proof of identity which takes the form of your email and password.

When you buy crypto through well-known exchanges, you are most likely going to have a custodial agreement with the exchange, by virtue of that custodial crypto wallet.

You are also relying on the security protocols of the exchange. Your only responsibility is to make sure that you do not share your account password, and do not compromise your email (which is used to recover forgotten passwords).

Benefits of Custodial Wallets

1. Ease of Use: Custodial wallets are user-friendly and ideal for beginners. The service provider handles the technical aspects of managing private keys and securing your funds.
2. Convenience: If you forget your password, the service provider can help you recover your account. This is similar to how banks can help you reset your password if you forget your online banking login.
3. Integrated Services: Many custodial wallets offer additional features like buying, selling, and trading cryptocurrencies within the platform.

Drawbacks of Custodial Wallets

1. Lack of Control: Since you don’t hold the private keys, you are dependent on the service provider. If the provider faces security issues or goes out of business, your funds could be at risk.
2. Privacy Concerns: Using a custodial wallet often requires you to share personal information, reducing your anonymity.

Can I store crypto without relying on a third party?

Absolutely you can! If you find that you can’t trust a third party to store crypto for you, there is another option — non-custodial wallets.

You may be surprised to read this: Non-custodial wallets are the original wallets in the crypto world. Back when crypto wasn’t well-known, tech enthusiasts used these wallets to send and receive crypto among each other without an intermediary like a crypto exchange.

Non-custodial wallets require a few extra steps, like backing up your wallet with recovery phrases, instead of an email address. But these days, most non-custodial wallets are quite intuitive. The setup process have been so refined that it’s easy to follow the setup instructions and doing it right.

Another advantage of storing crypto in a non-custodial wallet is that you are in full control of the security and management of your crypto funds.

You basically own the “master key” that has access to your crypto funds, and not a third-party custodian.

Learn the fundamentals: How do crypto wallets work?

When to use a custodial wallet

There isn’t really a rule that specifies when or why you should use a custodial wallet. A custodial wallet is simply going to offer you the following benefits:

• Intuitive setup processes
• Being able to manage all (or most) assets in one place
• Low-cost transaction fees (though not on all exchanges)

Most beginners in the crypto space opted for custodial wallets, simply because it’s more familiar than the non-custodial alternative. Some advanced traders also use custodial wallets to make day trading more affordable.

Some custodial providers make the process of creating a wallet as easy as creating a new social media account.

You just need to prepare your username or email address, a strong password, and supporting security tools, like 2-factor authentication with your mobile phone.

What is a Non-Custodial Wallet?

A non-custodial wallet, on the other hand, gives you full control over your crypto assets.

With a non-custodial wallet, you hold the private keys and are solely responsible for managing and securing them. Think of it as keeping your gold coins in a safe at home where only you have the key.

Example:

Imagine you have a safe at home where you keep your valuables. Only you know the combination to the safe, and you are responsible for its security. Similarly, with a non-custodial wallet, you have complete control over your cryptocurrencies.

Benefits of Non-Custodial Wallets

1. Full Control: You are the sole owner of your private keys, giving you complete control over your funds.
2. Enhanced Security: Since you are not relying on a third party, the risk of hacking or loss due to provider issues is minimized.
3. Privacy: Non-custodial wallets typically do not require you to provide personal information, preserving your privacy.

Drawbacks of Non-Custodial Wallets

1. Responsibility: You are fully responsible for securing your private keys. If you lose them, there is no way to recover your funds.
2. Complexity: Non-custodial wallets can be more complex to use, especially for beginners. They require a good understanding of how to manage and secure private keys.

When to use a non-custodial wallet

Again, the choice to use a non-custodial wallet over a custodial wallet comes from personal preferences. Non-custodial wallets offer you another set of benefits:

• You have full control over your wallet security
• Your transactions are more private
• You can decide how much to pay for each transaction (which affects how fast your transaction gets processed)

Many investors who are more experienced as they’ve spent months to years investing in crypto find themselves preferring non-custodial wallets over the custodial ones. This is primarily due to security concerns. It’s a fair reasoning — the longer you invest, the more wealth you accumulate in the form of crypto assets.

Eventually, these long-term investors want to be in control of as many factors as possible. They obviously can’t control the market volatility and the inherent risks associated with it.

However, they have learned that they could at least take security into their own hands, and not have to rely a company to manage their assets on their behalf.

Custodial vs. non-custodial crypto wallets

The differences between Custodial and Non-Custodial wallets are minor in terms of functionality, but when it comes to security and peace of mind the differences are quite significant. 

Custodial wallets entrust the security of your assets with a third party while offering the benefits of accessibility and ease of use (at least, for beginners). Non-custodial wallets leave you the full control of your fund’s security to your hands.

Someone with a large capital wanting to dive into cryptocurrencies as a way to diversify their assets may want to opt for a non-custodial crypto wallet for the utmost security.

So, as I prefaced early on – it comes down to your personal preferences, how much control you are willing to exert over your assets, and what features you seek for your crypto investment purposes.

While newcomers in the crypto space who want to get to know and familiarise themselves with digital crypto assets may find the custodial wallet option perfectly tailored to their needs.

Which One Should You Choose?

The choice between a custodial and non-custodial wallet depends on your needs and comfort level with managing your own security.

• For Beginners: If you’re new to cryptocurrencies and prefer a simpler, more user-friendly experience, a custodial wallet might be the best option for you.
• For Experienced Users: If you value privacy and control and are comfortable with the responsibility of managing your own security, a non-custodial wallet could be the better choice.

New to crypto? Here’s everything you need to know to get started.

Takeaways

When it comes to crypto storage, I feel like knowing and understanding the differences between custodial and non-custodial is just as important for anyone wanting to get into the crypto space.

Cryptocurrency has opened up a world for people to regain this responsibility essentially freeing you from reliance on a third-party entity.

As always remember to take responsibility for your wealth and investments. 

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