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The Difference between Custodial and Non-Custodial Wallets

  • Dec 9, 2022
  • 6 min read

Updated: Dec 12, 2022




There are two kinds of wallets - custodial and non-custodial. The former is offered by exchanges such as Binance, Kraken, Coinbase, and unfortunately, FTX. When you store your crypto assets on an exchange, the exchange has access to your private keys and can do whatever they want with your assets. That is what Sam Bankman-Fried did to bring on the demise of FTX. After the FTX debacle, there was a mass exodus of assets out of exchange custodial wallets into non-custodial wallets notwithstanding the assurances from the exchanges that they would not steal your crypto. With a custodial wallet like BitPay (also known as a self-custody wallet) you, and only you, have full access to and control over your 12-word secret recovery phrase and private keys. Who has custody over your funds is a very important issue in the world of crypto investing. It can all be distilled into one single word "permission". For example, if your crypto is in a custodial exchange, you need to ask permission from that exchange to withdraw your funds. According to CNBC, the top 50 creditors of FTX are owed over $3 billion and the largest single creditor is owed $226 million. Traditional banks are also custodial institutions. When you deposit your money in the bank, your money gets mingled with all the other depositors. This is known as fractional reserve banking and exchanges operate in a similar fashion. Banks make money by taking your deposits, paying you a few percent per year, and then lending that money out at 10 percent. Regulators force banks to hold at least 10 percent of total assets in reserves. So, if they have lent out $10 million, they must hold at least $1 million in reserves. The challenge is that FTX was not regulated so there were no reserve requirements. This means that all the assets that were held by customers on the exchange could be used by FTX. This is not stealing and only becomes an issue when the exchange is unable to pay back customers, and that is exactly what happened. Everyone is saying that SBF is a thief and should be thrown in jail. That may be true - but let me present to you an alternative opinion that may not get as many hits on the internet. Maybe SBF borrowed customer assets and then used them to trade Bitcoin. Again, banks do this all the time - it was one of the reasons Lehman Brothers failed in 2008. We all know that Bitcoin is in a bear market- its price has declined more than 70 percent over the past 13 months. Maybe SBF took a mega leveraged long bet on Bitcoin using customer money and was horribly wrong and lost customer money. Ok, let's now work through the pros and cons of a custodial wallet. On the pro side, if you are the kind of person that is forgetful and absent-minded, the custodial wallet on an exchange may be best for you because you are more likely to lose or let your seed phrase fall into the hands of bad actors. Also, if you are a newbie to the crypto space and you want to learn, it may be a good idea to start with a small amount of cash using a custodial wallet. If you forget your password you are able to approach the exchange which will assist you in regaining access to your wallet. On the negative side, we have already discussed how the exchange holds your private keys and may irresponsibly use your assets. The threat, however, is not only from within. Custodial wallets are also vulnerable to hackers. If you are a big-time hacker, are you going to spend your time trying to hack into the laptop of some schmuck working in Starbucks, or are you going to hack an exchange where the assets are? There is an old saying that if you want to steal lots of money, go to where the money is - ie the bank or an exchange. When you open an account at an exchange, you also have to go through the process of submitting documentation so that your account can be verified - that is another downside. Custodial wallets are nearly always web-based and are usually provided by centralized exchanges like Coinbase and Binance. The interface is designed so users never have to directly interface with their wallets and do not need to worry themselves over seed phrases and private keys. It is easy to buy, sell and send crypto off the exchange because the user interface has been designed for ease of use. The custodian of the private key (namely the exchange) is tasked with "signing" transactions using the private key to ensure they are completed correctly. Using a custodial wallet requires a great deal of trust in the institution which means you need to do your homework. In the wake of the FTX scandal, exchanges are doing their best to allay the fears of investors who have been pulling their crypto out. Major exchanges have been publishing proof of reserves (PoR). This is a verifiable auditing procedure that helps to enhance transparency to centralized cryptocurrency reserves. PoR uses cryptographic proofs, checks the ownership of public wallet addresses, and recurring third-party audits. It helps customers understand the platform's financial position and whether it has adequate funds to match customer deposits. Non-custodial wallets are also known as self-custody wallets in that you have complete control of your keys and therefore your funds. There are two different kinds of non-custodial wallets - hot and cold. A hot wallet is a software wallet in that it typically comes in the form of an app you download onto your phone or laptop, while a cold wallet comes in the form of an external device that can keep your data offline and out of the gaze of bad actors. Both types of wallets protect your public and private keys. The right type of wallet for you depends on how much crypto your hold, your security preferences, and how easily accessible you need your crypto assets to be. We are now going to do a blow-by-blow comparison of a hot versus cold wallet.

1) Price Almost all hot wallets are free. The most popular are Atomic, Coinbase Wallet, Electrum, Exodus, MetaMask, and Trust Wallet. A cold wallet, given that it comes in the form of a piece of hardware, can cost anything from $50 to $250. Three popular options are Ledger, SagePal, and Trezor. Whatever wallet you decide to use, it is important to check if it supports your crypto asset. Electrum, for example, only supports Bitcoin while MetaMask supports more than 500,000 because it integrates with many of the Web3 applications.

2) Suitability Hot wallets provide quick access to your assets which is perfect if you are a trader. If you are a long-term holder (or HODLer), you don't need access to your assets and the cold wallet is better for you. 3) Security Anything that is connected to the Internet is riskier than something that is not. Recently, hackers stole around $5.2 million worth of Solana from 8,000 hot wallets, such as Phantom, Slope, and Trust. Solana claimed that the security vulnerability was in the code of the third-party wallets and not in their own, but this could have been nothing more than a finger-pointing game. Solana has suffered numerous security breaches and it could be that this hack was not the fault of the wallets. However, although security in hot wallets is average, you need to know that the security of cold wallets is excellent. They cannot be accessed online, but they do require security measures to keep them from getting damaged, lost, or stolen. But if you lose access to your hardware wallet, all is not lost. For example, if you are using a Trezor wallet, the recovery method is quite simple. You go into their website and choose the option "create a new wallet". That will generate a new seed phrase. You need to make a note of all the public addresses for the coins you are using. To find these, click on receive and it should pop up with your public address. You need to remember that each crypto has a different public address. Public addresses are often compared to your bank account number, which is a good comparison, but there is a small shortcoming. When you transfer Bitcoin into your wallet, the address will not be the same as when you transfer Ether. Transactions are recorded on different networks (normally BTC for Bitcoin and ERC20 for Ether). Luckily, the software used to send crypto knows this. If you put an Ether address in for a Bitcoin transfer, the software will pick up the error and inform you. Now that the new wallet had been created, you need to recover the wallet of the lost device. You will do this with your seed. Once the wallet has been recovered, you will send your assets to your new wallet. 4) Transfer to Exchanges The interface between hot wallets and exchanges is easy because they are both online. Cold wallets on the other hand require an extra step to connect online through a USB, WiFi, or QR code. In summary, the biggest trade-off when it comes to wallets is between security and convenience. Whether you decide to go for a custodial or non-custodial wallet depends on whether you prioritize safety from potential online hacking or easy access to trading and staking. For a better balance of security and convenience, you can use a combination of both wallet types, storing easy-access funds online to trade and earn interest while keeping the keys to larger investments offline for longer-term storage.




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