Anyone who has been around the Bitcoin and cryptocurrency space for more than a couple of weeks has probably heard the phrase “Not your keys, not your Bitcoin.” But what does it mean?
In Bitcoin, the idea is to give the individual user complete control over their money. In other words, if used correctly, a user’s funds cannot be seized by third parties such as a government or financial institution.
To take full advantage of cryptocurrency technology, users need to understand the differences between custodial and non-custodial wallets when choosing the best crypto wallet.
Table of Contents:
What are custody wallets?
Custody wallets are despised by certain segments of the Bitcoin community. The basic idea is that your cryptocurrency is handed over to a third party to be stored rather than taking care of the funds yourself. The removal of third parties from the financial system is a clear point of this technology and explained in the original Bitcoin white paper, which is why custody wallets are sometimes referred to as Bitcoin banks.
Pros and cons of custody wallets
For
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If cybersecurity isn’t your selling point, you could let a third party protect your encryption.
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A third-party custodian can be helpful in making sure you don’t lose access to your funds.
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Custody wallets are often a requirement if you want to trade on the most popular cryptocurrency exchanges.
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Some custodians will offer you a return on your cryptocurrency-based savings.
Against
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You don’t own your private keys, which means security is left to third parties.
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Someone else is keeping your money to yourself, which means they might decide to simply take it.
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Custody wallets work very similarly to the traditional financial system due to the fact that they are centralized.
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You cannot access new cryptocurrencies created through forks of cryptocurrencies you already own.
What are non-custodial wallets?
Unguarded wallets are Bitcoin in its truest form. An unguarded wallet is simply software on your computer or phone that puts you in full control of your cryptocurrency holdings. You own your own private keys, which means no one else is able to make a transaction on your behalf. However, with greater power comes great responsibility.
Pros and cons of non-custodial wallets
For
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You have complete control of your Bitcoin, which means your assets are much harder to seize with.
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You can transact without anyone looking over your shoulder.
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You can access advanced features such as unattended access to the Lightning Network.
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Different levels of security can be activated depending on the threat model.
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Higher levels of security can be accessed through the combination of hardware and paper wallets.
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You will have full access to any dividend or stake premium associated with your cryptocurrency holdings.
Against
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It will be
more difficult to trade your cryptocurrency quickly, as it will first have to be sent to an exchange. -
Being responsible for your own safety comes with great responsibility, and human error could lead to theft or accidental deletion.
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You will usually be presented with user interfaces that are a little more difficult to understand.
Which is better: custodial or non-custodial?
The choice between a custodial or non-custodial wallet depends on what you’re trying to get out of your Bitcoin and how comfortable you feel with cybersecurity.
If you are someone who is not good with computers and is simply interested in Bitcoin for its monetary properties (the limit of 21 million), then using a custodial wallet will not be a big deal. It’s probably best to outsource a third party to help you not lose your entire investment, and as long as you use a trusted, regulated entity to store your funds, you’re unlikely to encounter serious problems.
If you are
interested in the cypherpunk philosophy behind Bitcoin or are able to figure out how to take responsibility for your cryptocurrency holdings, then we recommend that you choose a non-custodial storage solution. This will allow you to transact in a permissionless manner and put you in full control of your Bitcoin. This is how Bitcoin was to be used.
Why are custody wallets considered unsafe?
Custody wallets have a horrible track record, but have earned a better reputation in recent years. In the early days, there was a lack of regulation around Bitcoin and cryptocurrency custodians, which led many of them to lose customer funds to hackers or simply run away with the money themselves.
These days, there are many regulated, trustworthy, and often insured entities that are willing to keep your Bitcoins to yourself. In fact, you may even be able to get a return on your Bitcoin similarly to the traditional banking system.
However, if you are sufficiently computer savvy, taking care of your own cryptocurrency store is still the safest bet and follows in line with why this technology was created in the first place.
Do all exchanges offer custody wallets?
All major exchanges currently offer custody wallets, but new protocols are being used to improve the security of these exchanges and give users more control over their funds.
Exchanges like Kucoin and Nash use technology similar to Lightning Network to give their users full control over their crypto assets to the point where they want to place a sell order. It’s likely that more exchanges will offer this type of security update over time, but for now custody wallets are still the standard for most exchanges.
Are there exchanges with non-custodial wallets?
There are some exchanges that have unguarded portfolios, but they generally do not have the same level of trading volume found on the most popular exchanges in the world. Fully peer-to-peer options like Bisq intend to maintain Bitcoin’s core philosophy and offer a decentralized solution that does not rely on third parties.
There are a number of other blockchain-based decentralized exchanges that have popped up on smart contract platforms like Ethereum, but they have encountered a number of problems, particularly issues associated with frontrunning.
The model that ends up working for the best in the long term may be one that doesn’t try to be as decentralized as possible, while at the same time allowing its clients to hold their own funds. With this configuration, users have control of their own private keys, but the exchange likely uses a centralized order book for efficiency purposes.
Are hardware wallets always unguarded?
If you are using your own hardware wallet, then it is completely unguarded. The only time a hardware wallet is used unguarded is when it is used to secure an exchange’s offline cryptocurrency holdings on behalf of its users.
How do I set up an unattended wallet?
We have a comprehensive guide to setting up crypto wallets, but it’s not an overly complicated process. It typically includes most of the following steps:
- Buy or download your favorite wallet
- Write down your 12- or 24-word recovery seed phrase (it’s important to keep it offline)
- Create a password or pin
- Connect your hardware wallet to your computer (if you have a hardware wallet)
- Access your wallet
- Send cryptocurrency to your wallet
A note about recovery seed phrases: Every time you generate a new crypto wallet you are usually given 12 or 24 random words. They can be used to recover your crypto wallet if your physical device or computer is lost or otherwise compromised.
Therefore it is extremely important to store the recovery seed phrase in a safe place (such as a real safe). Some people even like to emboss metal plates with their recovery seed phrase for even greater safety. These are sometimes referred to as metal crypto wallets.
