Custodial or Non-Custodial - That Is The Question?

The extent to which someone decides to use a custodial or non-custodial crypto wallet or exchange is one of the most important choices to be made in this space, yet it’s possibly one of the least understood by newer members of the ecosystem. This article is focussed around solutions for individuals rather than potential institutional investors who have a very different set of regulatory compliance requirements, impacting this freedom of choice.

Definitions & Examples

Custodial

Custodial wallets/exchanges retain control of your private keys and thus your coins. You therefore do not have complete control over your money and are trusting that third party with your funds. Examples of custodial wallets/exchanges include Coinbase, Freewallet, Cryptopay, Bitfinex, Binance and Bitstamp.

Non-Custodial

Non-Custodial wallets/exchanges ensure you retain complete control over your private keys and essentially enable you to be your own bank. Non-Custodial wallets can be broken down into hardware, paper, web, desktop and mobile versions. Examples include Ledger, Trezor, MyEtherWallet, Edge, Shapeshift and Changelly.

Custodial

Pros

• Easy to use UI.
• Fast and convenient way to get started in crypto.
• Simple on-ramp/off-ramp to fiat where available.
• People are already used to custodial services and rightly or wrongly trust them.
• No risk of you losing you own private keys as with paper wallets.
• No additional costs compared to hardware wallets.
• Some can offer superior security standards and cold storage for peace of mind.
• Less technical knowledge is required.
• Less individual responsibility.
• No software downloads necessary - simple login via web or app.

Cons

• It brings back a required element of centralised trust to a system that is supposed to be decentralised and trustless.
• Both your data and funds are at custodial risk.
• Your funds could be seized by local authorities.
• Large wallets/exchanges are attractive targets to hackers, putting your coins at additional risk.
• They can be hot wallets operating frequently online which are the least secure.
• When forks occur, not all custodial wallet/exchange solutions will provide the forked coins to you and may retain them themselves.
• The third party custodian has control over your money, so it’s not much different than using a bank in this regard.

Use Cases

A principle use case for custodial wallets or exchanges is as a simple, easy way to introduce new people to the space. Convenience often wins, despite other risks. They may also be a necessity for frequent traders who need to have funds in place for quicker trades/exchanges, whilst accepting greater security risk. Sometimes you will also have no choice but to at least temporarily use custodial exchange services for coins or tokens that are not exchangeable in a non-custodial way.

Non-Custodial

Pros

• You retain full control over your coins or tokens.
• Your funds cannot be easily seized by local authorities.
• The latest hardware and desktop/mobile non-custodial wallets make it far easier to manage private keys with less technical knowledge.
• No risk of fund loss due to a custodial wallet/exchange hack.
• More secure, predominantly offline cold storage capability with paper and hardware wallets.
• You also maintain control over and receive any forked coins.
• Your data is also secure and remains in your control.

Cons

• Retaining control requires maintaining far greater responsibly. You are your own bank and responsible for your own security measures.
• Risk of loss of paper/hardware wallets, computers and mobiles.
• Hardware wallets incur additional expense.
• The process of moving and exchanging assets can be slower and less convenient.
• Web, desktop and mobile wallets are still warm (more likely to be connected to the internet more frequently, and therefore still carry reasonable security risk).
• Can require more technical knowledge/updates.

Use Cases

Non-custodial wallets/exchanges are more desirable for the technically minded, users wishing to manage larger amounts, those wanting to be their own bank (avoiding centralisation and the need for trust), and those with greater security concerns.

Verdict

There are certainly use cases for both types, and the decision will essentially depend on each individual, their background/experience and utilisation context. Custodial wallets/exchanges are understandable for smaller amounts, newer members of the ecosystem and frequent traders, but less safe for larger amounts with significant risk of hack and/or custodial closure. Non-custodial is far more secure but comes with additional responsibilities. As non-custodial solutions develop through improved UI and convenience, decentralised exchanges and atomic swaps, it should become easier for everyone to move over to these more secure solutions. Some may always choose convince over risk mitigation and control, others perhaps don’t have much choice for now, but the important thing is to only expose assets for the shortest time possible on custodial solutions. And remember, whoever holds the keys, holds the crypto.

Disclaimer: Investing or trading in cryptocurrencies involves significant risk. All the information presented in this article does not constitute financial advice or recommendations of any kind.

By James Hunt (@humanjets)