Custodial and non-custodial wallets are the two main options for storing crypto and other digital assets. That said, both of these types of wallets have their fair share of pros and cons. So, how do you know which is right for you?
Below you’ll learn what a custodial and non-custodial wallet is, how they differ, and how to choose the right one for you.
What Is a Custodial Wallet?
A custodial wallet stores your private key for you. Hence, the wallet provider is in complete control of your wallet and any asset within. Most custodial wallets are provided to users by centralized cryptocurrency exchanges, which are often web-based.
These exchanges make it easy for users to interact with blockchain technology by managing the private key for you. Hence, if you forget your password you can easily reset it by answering some basic security questions—similar to any other online account you might have, such as social media.
With a custodial wallet, the exchange is tasked with signing blockchain transactions initiated by the user to ensure it’s completed successfully. With that, custodial wallets can easily connect to decentralized applications (dapps) along with staking and yield farming platforms.
To be fair, there are some cons to custodial wallets though. Since these wallets live online via a centralized entity, they’re often targeted by hackers. That’s one reason why billions of dollars have been stolen from such exchanges.
And it gets even worse. If the exchange that controls your wallet goes bankrupt, all of your funds could be instantly frozen leaving you empty-handed. This is exactly what happened with the popular cryptocurrency exchange FTX.
Using a custodial wallet without doing your homework first is like lending money to someone you just met—hoping they’ll return it to you the moment you ask.
A trusted and reliable exchange is generally federally regulated, meaning they adhere to numerous laws, and may even offer insurance coverage to protect its users.
Additionally, many custodial wallets require ‘know your customer’ (KYC) and ‘anti-money laundering’ (AML) verification. Although this is in place to keep the company and its users safe, it lengthens the time it takes to create a new wallet.
Pros:
- Great for beginners who don’t want to manage their private keys.
- Low barrier to entry for crypto for those new to crypto.
- You can easily recover your password if you lose or forget it.
Cons:
- Custodial wallets are often targeted by hackers.
- Your private key and assets are controlled by a third party.
- Requires KYC and AML verification prior to use.
What Is a Non-Custodial Wallet?
A non-custodial wallet enables the user full control of their private key and any assets within the wallet. Hence the saying, “not your keys, not your crypto”, meaning if you don’t own your private key, you don’t actually own your assets.
With this ownership comes more responsibility and technical know-how. That’s why non-custodial wallets are preferred by those with a deeper understanding and a greater curiosity about blockchain technology.
In addition to this increased responsibility, there are several types of non-custodial wallets, each with its own level of technical know-how required to use it.
Browser and app-based wallets (aka software wallets) are in their own category and are often thought to be the least secure type of non-custodial wallet. The reason being is that the software is connected to the internet 24/7, making it more prone to hackers and various scams.
On the other hand, a physical device (aka a hardware wallet) is another kind of non-custodial wallet that’s known as the most secure wallet you can get. Since your private key is stored on the device itself and not online, it’s virtually impossible to hack.
Nonetheless, a non-custodial wallet’s greatest upside just happens to be its biggest downfall. That is, if you lose your private key, you lose access to your wallet and everything in it. There’s no recovery method and no one to reach out to for help. You’re on your own.
However, every non-custodial wallet automatically generates 12-24 random words to create a secret recovery phrase. This phrase is used to restore your wallet, and anyone who knows your phrase has complete access to your wallet.
Of course, this phrase is equally as important as your private key considering it’s technically the same thing. So if you lose your private key and your recovery phrase, you lose your wallet and your funds.
Pros:
- You control your keys and assets.
- Funds remain secure even if an exchange is hacked.
- No KYC or AML verification is required to create a wallet.
Cons:
- No way to recover your wallet if you lose your private key.
- There’s a greater learning curve to using a non-custodial wallet.
- Non-custodial wallets may not be suitable for those new to crypto.
