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 this mean? In Bitcoin, the idea is to give the individual user complete control over their money. In other words, when used properly, a user’s funds cannot be seized by a third party such as a government or financial institution. To take full advantage of cryptocurrency technology, users must understand the differences between custodial and non-custodial wallets.
By: Arthur Crowson | Jan 16, 2020 | Modified Apr 9, 2020
Custodial wallets are despised by some segments of the Bitcoin community. The basic idea is your cryptocurrency is handed over to a third party to be stored rather than taking care of the funds on your own. 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 custodial wallets are sometimes referred to as Bitcoin banks.
Non-custodial wallets are Bitcoin in its truest form. A non-custodial wallet is simply a piece of software on your own computer or phone that puts you in full control of your cryptocurrency holdings. You hold 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.
Choosing between a custodial or non-custodial wallet depends on what you are trying to get out of your Bitcoin and how comfortable you are with computer security.
If you are someone who is not good with computers and is simply interested in Bitcoin for its monetary properties (the 21 million cap), then using a custodial wallet won’t be that big of a deal. You’re probably better off entrusting a third party to help you make sure that you don’t end up losing the entirety of your investment, and as long as you use a trusted, regulated entity to store your funds, you’re unlikely to run into any serious issues.
If you’re interested in the cypherpunk philosophy behind Bitcoin or are able to understand how to take responsibility for your own cryptocurrency holdings, then you’ll want to go with a non-custodial storage solution. This will allow you to make transactions in a permission-less manner and put you in completely control of your Bitcoin. This is how Bitcoin was intended to be used.
Custodial wallets have a horrible track record, but they’ve gained a better reputation over the past few years. In the early days, there was a lack of regulation around Bitcoin and cryptocurrency custodians, which led to many of them losing customer funds to hackers or simply running away with the money themselves.
These days, there are plenty of regulated, trusted, and oftentimes insured entities that are willing to hold your Bitcoin for you. In fact, you may even be able to gain a return on your Bitcoin in a manner similar to the traditional banking system.
However, if you are sufficiently computer literate, taking care of your own cryptocurrency storage is still the safer bet and follows in line with why this technology was created in the first place.
Every major exchange currently offers custodial 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 the Lightning Network in order to give their users full control over their crypto assets up until the point they wish to make a sell order. It is likely that more exchanges will offer this sort of security upgrade over time, but for now, custodial wallets are still the standard for most exchanges.
There are some exchanges that feature non-custodial wallets, but they generally do not have the same level of trading volume found at the most popular exchanges in the world. Completely peer-to-peer options like Bisq intend to keep with Bitcoin’s core philosophy and offer a decentralized solution that does not rely on any third parties.
There are a number of other blockchain-based decentralized exchanges that have popped up on smart contract platforms like Ethereum, but they’ve run into a number of issues, most notably problems associated with frontrunning.
The model that ends up working out for the best in the long run may be one that does not try to be as decentralized as possible while also allowing their customers to hold their own funds. With this setup, users are in control of their own private keys, but the exchange likely uses a centralized order book for efficiency purposes.
If you are using your own hardware wallet, then it is completely non-custodial. The only time a hardware wallet be used in a non-custodial manner is when it is used to secure an exchange’s offline cryptocurrency holdings on behalf of its users.