Custodial cryptocurrency businesses are the ones that are in possession of their customers’ funds for the duration of the use of their services.
Traditionally used in relation to cryptocurrency
wallets or
exchanges, a custodial setup is one in which private keys, which are required to access a customer’s funds, are held by the service provider while they offer a login account.
One of the defining characteristics of
cryptocurrencies is the fact that they always remain under full control of their owners: every public address is associated with a private key that only the owner knows and without which no other person can access the funds stored on that address.
While this setup is one of the main selling points of crypto to some, others may consider the task of diligently managing their own keys not worth the advantages of keeping unconditional custody over their own funds. In this case, custodial wallets are available, which take over the management of a user’s private keys and allow them to access their funds via a simple and familiar login-password setup.
Centralized cryptocurrency exchanges are another common type of custodial service. They allow customers to deposit cryptocurrency funds onto an exchange account and then trade them for other cryptos or
fiat currencies. The trades are not recorded directly on the blockchain, but rather on the exchange’s internal balance sheet. Meanwhile, every customers’ funds are held in custody from the moment they are deposited to the moment they are finally withdrawn from the exchange.
While easy to use and efficient, these services are associated with custodial risks: by storing many customers’ funds in one place, they become a likely target for
hackers, government censorship or simple accidents like hardware malfunctions.