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Whether you’re just curious, want to invest in different altcoins, or believe in the decentralized nature of cryptocurrency, it’s important to secure your digital funds.
The wallet you choose is an important factor for any crypto investment. There are many types of wallets, from paper wallets to software wallets to hardware wallets. Regardless of your choice, it will fall into one of two categories: custodial or non-custodial.
Custodial wallets are controlled by a third party and are usually the easiest to access and set up. Non-custodial wallets, meanwhile, are fully controlled by you. That makes them more secure, but they also come with a lot more responsibility.
Understanding the key differences between custodial and non-custodial wallets can help you determine which crypto wallet or combination of crypto wallets is best for you and your crypto investing journey.
The Short Version
- If you own crypto, you should keep your private keys secure in a wallet.
- There are two categories of wallets: custodial and non-custodial.
- Custodial wallets managed by third parties are easier to use but less secure.
- Non-custodial wallets are more secure but more complex — and if you lose your password, you lose access to all of your crypto.
What Is a Cryptocurrency Wallet?
If you purchase cryptocurrency, you need somewhere to store it. Crypto is not regulated like fiat currency (such as U.S. dollars), so you can’t store it in your bank. Instead, you need a digital wallet or storage place that lets you secure your crypto investments.
Crypto isn’t represented by physical tokens like paper money or coins. It’s simply a string of code on a type of ledger called a blockchain. In other words, crypto is a digital currency verified and recorded on a decentralized system.
When you purchase crypto like Bitcoin, you own a public and private key on the blockchain. These keys unlock your crypto and allow you to use it. The public key is like your bank account number. You can give it to anyone who wants to pay you. Your private key is like your password. You want to keep it secret because it gives you complete access to your crypto.
A crypto wallet is where you store your keys. There are a few places where you can keep your keys, such as a desktop wallet, USB device, software wallet, and even paper wallet. Regardless of which wallet you choose, it will be categorized as either a custodial wallet or a non-custodial wallet.
Read more >>> The Best Cryptocurrency Wallets
What Is a Custodial Wallet?
A custodial wallet is one where a third party holds your crypto keys. Most web-based crypto wallets are custodial wallets. Many crypto exchanges like Coinbase and Binance offer crypto wallets, but you can also have your keys in a specific online wallet provider.
A custodial wallet is a bit like a bank, where the money is yours but is controlled by the bank itself. In that way, the service provider governs a custodial wallet, but the keys (and crypto) belong to you. You’re not responsible for the security of the private keys; instead, you place your trust in an institution to keep your keys safe for you. However, since you’re entrusting your keys to a third party, you need their permission to complete transactions.
Users often opt for custodial wallets because they are easy to use. If you want to access your crypto, simply login to the custodial account. And if you forget your password, you can reset it. Likewise, if you have an issue with a transaction or questions about accessing and using your crypto, you can reach out to the custodian’s customer service center.
However, there is a bit of risk with a custodial wallet, as it can be hacked. You could lose your private keys and, with it, access to your crypto. Also, in some cases an exchange may freeze assets due to government sanctions or requests from law enforcement authorities.
Finally, it’s possible some assets could be lost in the event of an exchange going bankrupt. We’ve seen a spate of bankruptcies in the cryptocurrency industry this year, including most recently FTX and BlockFi. We’re in the early stages of the Chapter 11 proceedings for these companies so it’s yet to be seen if customers will be able to recover all of their digital assets or if some will be lost.
Custodial Wallet Pros and Cons
pros
- Easy to use. You simply log in and can access and manage your crypto.
- Convenient. You don’t have to worry about losing your keys because the custodial account manages them for you.
- Customer support. If you forget your password or have an issue with a transaction, most custodial services have a customer service center you can reach out to.
cons
- Third-party control. Since the custodian is in charge of keeping your private keys safe, they technically have control of your crypto assets, and you need to get permission from them to complete transactions.
- Risk of hacks or bankruptcy. There is a more significant risk of an exchange or wallet losing some of your crypto holdings by being hacked or going bankrupt.
- Internet accessibility. You need the internet to access your account, which could be an issue if you’re traveling or live in a remote area and don’t have access to the internet.
What Is a Non-Custodial Wallet?
With a non-custodial wallet, users have complete control of their keys and crypto. Only the user has access to the wallet’s private keys. Because of this, non-custodial wallets are considered more secure. In other words, assets are not subject to censorship, and it’s much harder to hack.
Non-custodial wallets are a bit more complex to set up. In addition, if you lose your keys or passwords, you cannot recover them. Likewise, if you don’t back up your wallet correctly, you can also lose access to all the funds held in the wallet.
Users have lost millions of dollars in crypto from lost private keys or seed phrases. Software developer Stefan Thomas famously lost $312 million worth of Bitcoin in 2021 because he simply lost the password to his USB hard drive with his digital wallet.
Some examples of popular non-custodial wallets include Exodus and Ledger Nano X.
Non-Custodial Wallet Pros and Cons
pros
- More security. Non-custodial wallets are more secure and less vulnerable to hacks than custodial wallets.
- You’re in control. Because you’re the only one with access to your password, you aren’t subject to censorship, freezes, or loss of assets due to your custodian becoming insolvent.
- More privacy. With non-custodial wallets, you often don’t need to provide personal identifying information, keeping your transactions anonymous.
cons
- More complex. Non-custodial wallets are complex and can be confusing to set up for first-time users.
Slower transactions. Trade execution on non-custodial wallets tends to be slower, and funds may need to be transferred to a custodial wallet for quick access to cash. - Burden of responsibility. If you lose your password, you may not be able to get into your wallet and lose all access to your funds.
Key Differences Between Custodial vs. Non-Custodial Wallets
To summarize, the key difference between custodial vs non-custodial wallets comes down to who has control of your private keys.
With a custodial wallet, a third party has control of your keys. It requires trust to keep your keys safe and secure from hackers. However, there is a higher risk of data breaches. There is also less anonymity with custodial wallets, as these companies are often regulated by “Know Your Customer” rules. Some users who liked the privacy offered by crypto might not want to hand over their personal information to the custodian.
With a non-custodial wallet, you have control of your keys. You can use a USB stick that connects to the internet or write down your keys on a piece of paper and put it in a safe. However, if you lose your private keys or password, it’s game over.
There is no getting your Bitcoin or Ethereum back.
The Takeaway: Should You Use a Custodial or Non-Custodial Wallet?
There is no right or wrong way to store your crypto. It all depends on your personal preferences.
If you’re buying crypto for the first time, it might make sense to start with a custodial wallet as they are easier to use. You can always move to a non-custodial wallet as you learn more about crypto and securing your assets.
Some crypto users opt for a combination of custodial and non-custodial wallets. They might use a custodial wallet for easy access and transactions but keep most of their crypto in a more secure, non-custodial wallet.
One final note: should you decide to store any of your digital assets inside a non-custodial wallet, you may also want to consider if you’d like it to be a hot or cold wallet. Learn how they compare here >>>
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