Custodial vs Non-Custodial Wallets

A crypto wallet is used to store your private keys, allowing you to securely access your cryptocurrencies like Bitcoin or Ethereum. Unlike a normal wallet which may hold wads of cash, a crypto wallet does not technically store your crypto assets. Instead, the assets live on the blockchain, and can only be accessed using your private keys that are stored on the wallet.

Crypto wallets can be custodial or non-custodial — both store your private keys, proving the ownership of your digital assets. Your keys allow you to sign transactions, transfer cryptocurrencies and interact with smart contracts.

However, losing your private keys means that you also lose access to your crypto holdings. Therefore, it is imperative that you understand how crypto wallets work, and how to keep your keys secure. Read on to find out more.

Types of Wallets

There are two main umbrellas of wallets:

Furthermore, each crypto wallet includes two important components.

Public key
Private key

Public and Private Crypto Wallet Keys

A public key is the public-facing address of your wallet. You can think of public keys like your home address — you use it when you want something delivered to your place.

In crypto terms, the keys serve the purpose of receiving inbound cryptocurrencies and handle the encryption of outbound transaction data. While depositing cryptocurrency to a wallet, a public key is required to be entered as the deposit address.

Meanwhile, a private key is akin to the password used to access your digital assets. It also proves ownership over those assets stored in the wallet, and is used to transfer cryptocurrencies out of the wallet.

An important thing to note: your private key should not be shared with anyone. Anyone with control holds ownership over that wallet and can move the assets inside that particular wallet as he wishes. One too many crypto hacks have occured due to crypto users being duped to share their private keys.

Custodial Crypto Wallets

Various wallet services offered by centralized entities, like a centralized exchange (CEX), are known as custodial wallets. These wallets come with certain benefits attached to them, such as less user responsibility as compared to managing your own wallets.

Outsourcing your wallet custody means that you are giving away access to your own set of private keys. In short, the user is not responsible for protecting their private key to their wallet, as they already have placed their trust in a business into keeping their assets safe. However, many CEXs also offer non-custodial wallet solutions, such as Binance Chain Wallet, Coinbase Wallet and Crypto.com DeFi Wallet.

How Do Custodial Wallets Work?

In order to make a successful transaction through a custodial wallet, the user is required to log in to the platform with their username and password and then enter the public key of the location where they wish to make the transfer.

After that, the business takes over and is directly responsible for making the transaction on their own as the funds are stored on the wallets that they own.

Pros of Custodial Wallets

As mentioned, the private access keys are not your responsibility. You do not need to worry about forgetting your key, and even if you misplace your password, you can always request that the CEX or wallet provider recovers your account.

Some businesses that offer these custodial wallet services also offer a backup option. Backups enable users to undo transactions or restore a previous version as every step is recorded and backed up to the company’s server.

Cons of Custodial Wallets

While it may be a simpler option, users need to note that they are exposed to the risk of exploitation or hacks that the wallet provider might suffer. There have been several hacking cases, including loss of funds held in custody.

While not exactly a wallet provider, another risk — which became evident in the recent downturn — is the possibility of having your funds locked up. Many who deposited money, some their life savings, into custodial accounts on Celsius or Voyager were unable to withdraw after the companies declared bankruptcy.

Furthermore, certain governments have completely banned the use of custodial wallets for completing transactions for users in certain areas. In times of political unrest, this means that governments have more power to restrict movement of funds in custodial wallets. For example, during the Canadian trucker protest in early 2022, the government ordered a freeze on the crypto assets of the protestors held in custodial wallets.

Another drawback of a custodial wallet is that users are usually required to perform KYC (Know Your Customer) verification: for most custodial wallets, users are not allowed to access any features or assets without proving their identity.

Non-Custodial Wallets

As most of you have already guessed, non-custodial wallets do not require any sort of third-party involvement like custodial wallets do. They don't outsource to any institution, so as a result, no institution can refuse to complete transactions.

A user has total control over their own private keys: none of their transactions have to go through centralized third-parties.

Pros of Non-Custodial Wallets

Non-custodial wallets serve the purpose of ensuring the confidentiality of a user's assets. However, that comes with the responsibility of storing your private keys, which are the sole way of accessing your account.

Unlike custodial wallets, users can easily access their stored funds in any situation and without KYC, as there is no need for a confirmation notice from any third party. Instant withdrawals are available in non-custodial wallets, while some CEXs require a certain time to process transactions.

Cons of a Non-Custodial Wallet

Security is a big concern when it comes to non-custodial wallets. As you are in complete control of your own private keys, your funds are gone forever if those keys are lost or stolen. Case in point: the man who lost his hard drive containing 7.500 BTC, worth over $185 million at the time of writing.

It's important to take measures to ensure the safety of your private keys. Because, as secure as it may be, even the owner of the wallet himself can't access their wallet if the private key is misplaced or lost.

Unlike custodial wallets, non-custodial wallets aren't often particularly user-friendly. Beginners may have a steeper learning curve and require some time before getting to know how to use these wallets.

When it comes to non-custodial wallets, the recovery of funds is a bit more complicated and in some extreme cases even impossible, which is why it is important to be extra careful when using them.

In the event that you do lose access to your non-custodial wallet, the first thing you should do is reach out to the wallet's support team. If the wallet's support team is unable to help you, you can try reaching out to the blockchain's support team. And if all else fails, you can try contacting the exchanges where you purchased your cryptocurrency.

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