How does a crypto wallet work?
First and foremost, it’s important to understand what a crypto wallet's private keys are.
Since balances of how much cryptocurrencies individuals own are always represented by their respective blockchains, wallets don't literally store digital tokens. Instead, a wallet provides users with a unique blockchain address in the form of private and public keys. While the public key is viewable to all, the private key gives users the ability to control an address and transact.
To determine whether a wallet is custodial or non-custodial, you should always ask, "Who's holding the private keys?" If a digital wallet gives you a private key "seed phrase" while installing it, it's a self-custodial crypto wallet. Wallets that don't provide users with their private keys are custodial.
What is a custodial crypto wallet?
Remember, a custodial crypto wallet doesn't allow users to own their private keys. With these wallets, a third party always holds the private keys on a user's behalf. Therefore, when you put your crypto in a custodial wallet, it's not 100% under your control. Whoever owns the private keys can restrict access to your crypto at any moment and even seize the funds.
The most common style of a custodial crypto wallet is an "exchange wallet." As the name suggests, exchange wallets are associated with centralized exchanges (CEXs). When you buy and store crypto on a cryptocurrency exchange like Coinbase or Binance, the company holds the private keys to your crypto. Many centralized crypto companies and lending sites also offer custodial crypto wallets.
Most custodial wallets are only available as desktop or mobile apps. While the third-party custodian may store your crypto in hardware servers, you won't have access to these devices or storage facilities.
What’s a self-custody wallet?
A self-custody wallet (aka non-custodial wallet) will always give you access to your private keys. Whether you download a software application or purchase a hardware device, these wallets will first give you a 12 to 24 word list known as a seed phrase. This elaborate passcode signifies your private keys. You can use your seed phrase to recover crypto should your phone, computer, or hardware wallet break.
Self-custody wallets come in two varieties: hot and cold wallets.
Hot wallet versus cold wallet: Hot wallets are software applications that are always plugged into the internet, while their cold counterparts store a user's private keys offline. Although it's possible to use "paper wallets" with your private keys on a sheet of paper, hardware devices are the most common form of cold storage in today's crypto industry.
Custodial vs. self-custodial wallets
Now that we know what these wallets are and how they’re used, let’s take a look at their advantages and disadvantages.
Custodial wallets
Pros
- Most custodial wallets have a beginner-friendly user interface.
- No need to worry about forgetting, storing, or losing your private keys.
- It's possible to recover access to a wallet even if you forget your password.
- Many prominent custodial wallets have insurance protections and a customer service division.
Cons
- Crypto users don't have full ownership of their digital assets.
- Since crypto custodians are centralized, one successful hack can drain your funds.
- Crypto custodians often require KYC (know-your-customer) info, thus putting your identity at risk.
Self-custodial wallets
Pros
- These give you full control over your digital assets.
- You can use many self-custodial wallets to interact with Web3 dApps.
- High-quality hardware wallets are virtually unhackable.
- There's no need to provide KYC info.
Cons
- If you lose your private keys or get hacked, there's no chance you can recover lost tokens.
- If you’re a little short on technology, you may struggle a bit to use self-custodial wallets.
- Many of these wallets don't have customer service representatives, though Worldcoin's flagship wallet does.
Are self-custodial wallets safer than custodial wallets?
Some users assume self-custodial wallets to be inherently "safer" than custodial wallets since these wallets provide private keys. However, in reality, a wallet’s safety largely depends on its underlying technology and the reliability of its custodian.
Self-custodial software wallets are still prone to hacks and phishing attacks. Not every self-custodial wallet is created equal, so users have to double-check the reputation of their wallet. Also, anyone who has access to your private keys can access your crypto funds and drain your account.
When you download a self-custodial wallet, you take on the responsibility of a crypto custodian. If you feel comfortable securing your private keys, you may enjoy a self-custodial wallet's freedom.
Something to remember: Some prominent custodial wallets grant customers insurance protections during a hack. Some crypto holders feel more comfortable entrusting their crypto to a reputable and insured third-party custodian like BitGo or Coinbase Custody. Although there’s no guarantee that custodians will make good on their promises, these protections may provide some comfort for passive crypto investors.
Examples of custodial wallets
Every major CEX provides users with access to a custodial hot wallet. Also known as an "exchange wallet," this application is connected to the crypto trading account on your preferred CEX. Whenever you buy crypto on a CEX like Coinbase or Binance, it’ll instantly go into your custodial wallet.
Centralized crypto lending platforms like BlockFi and Nexo also have custodial crypto wallets for their clients. Many stock trading platforms that offer crypto investing also have custodial hot wallets. For instance, Robinhood and eToro have custodial crypto wallets.
Lastly, a few professional crypto custodians offer crypto storage features. BitGo, Gemini Custody, and Coinbase Custody are a few of the most prominent names in this field. Typically, institutional clients, businesses, and crypto whales will request the services of a professional crypto custodian.
Examples of crypto self-custodial wallets
As more crypto wallets enter the market, choosing the best self-custodial wallet is becoming increasingly difficult. While selecting the "right" crypto wallet depends on your personal preferences, a few self-custodial wallets have gained prominence in the crypto community.
In the hardware wallet category, Ledger and Trezor are two of the crypto industry's largest manufacturers. While there are competing companies like ShapeShift, these two manufacturers tend to rank as the leading global hardware wallet producers (at the time of writing).
As for hot self-custodial wallets, there are too many options to list in one post. However, a few of the most downloaded non-custodial crypto wallets include:
- Worldcoin
- Trust Wallet
- MetaMask
- Coinbase Wallet
- Exodus
- Crypto.com DeFi Wallet
- Atomic Wallet
Remember, the Coinbase Wallet and Crypto.com DeFi Wallet are distinct from the custodial hot wallets on each company's centralized trading platform. Sometimes, crypto exchanges offer non-custodial wallet options. Therefore, you don't need a Coinbase or Crypto.com account to use these apps.
How to choose between custodial vs. self-custodial wallets
Choosing between a custodial or a non-custodial wallet depends on how comfortable you feel protecting your private keys. If you feel afraid to take on the responsibilities of a non-custodial crypto wallet, chances are you'd prefer the insurance protections some high-profile crypto custodians offer.
While there's no guarantee a third-party custodian will always act in their clients' interests, you may have more legal options should something happen to your funds. Also, custodial wallets often offer professional customer service to help address your concerns or questions.
However, if you want complete ownership of your crypto or you're interested in DeFi (decentralized finance), you’ll need a non-custodial crypto wallet. These wallets will never offer the insurance protections some custodial wallets have, but they remove the risk that a third party will unexpectedly freeze your crypto assets. Self-custodial crypto wallets also provide increased privacy and anonymity since they don't require KYC documentation.
Remember to consider why you're investing in crypto and the pros and cons of each option. Addressing your financial goals can help you choose where to store your crypto.
Wrapping up
Although self-custody is a defining feature of cryptocurrencies like Bitcoin (BTC), it may not be the right storage option for every investor. Whether you choose a custodial or non-custodial wallet, do plenty of research into the app you're considering. Remember to work with crypto wallets and companies with a strong following and a solid track record in the blockchain industry.
At Worldcoin, we aim to make everyone feel empowered to safely experiment with self-custodying crypto. That's why we're airdropping free DAI stablecoins to anyone who downloads our app. We intend to put a free share of our crypto in everyone’s hands. Subscribe to our blog to learn more about the cryptocurrency ecosystem, including smart contracts, crypto staking, blockchain technology, and NFTs (non-fungible tokens).
