Custodial vs. Non-Custodial Wallets

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5 min read

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When it comes to cryptocurrency, understanding what you are in control of helps you manage your assets better. While it may seem pretty straightforward that a wallet you can use means you have control over the cryptocurrency it contains, this isn't always strictly the case, and there can be some nuance to the situation. If you've ever used a cryptocurrency exchange, there's a good chance you have used a custodial wallet, and perhaps you weren't fully aware of what you were giving up in the process.

What is a Non-Custodial Wallet?

A non-custodial wallet allows you to manage your cryptocurrency while retaining complete control. The primary difference for a wallet to be non-custodial is that you must have access to your private keys (an alphanumeric string) or mnemonic (12-24 word phrase) to freely control this wallet in the truest sense of the word. You may have heard people saying, "not your keys, not your crypto," and this is at the core of why it's essential to know whether a wallet you are using is actually custodial or not. If you have full access to your keys, you have full access to your funds.

LocalCoinSwap is an example of a platform that provides non-custodial wallets for Bitcoin, Ethereum, Polkadot, Kusama, and several ERC-20 based tokens. When you create an account on the platform, it's important you remember your password, as this is used in the generation of your wallets. The platform can only check that you have entered the correct password, not matching it against the password directly. Your password isn’t stored anywhere on the platform to ensure that only you control your private keys and the wallets are indeed non-custodial. This is achieved through client-side encryption, where your private keys are only handled in your browser, not a remote server. The only significant downside to LocalCoinSwap providing these non-custodial wallets is that your password can't be reset as your password isn't stored anywhere on the platform.

The Drawbacks of Using Custodial Wallets

  • A third party is inherently controlling your funds when using managed wallets
  • If the wallet provider shuts down, you won't be able to access your funds
  • Should the platform restrict your account in some way, you have little recourse
  • You cannot use your private key to access your funds with other wallets
  • Losses by the platform holding your funds can affect you directly
  • Slow withdrawals and they may need manual approval or other interventions

How to Start Investing in Bitcoin with a Non-Custodial Wallet

Investing in bitcoin for the first time is absolutely one of those moments where you want to feel safe and secure. Putting your money into an asset class like a cryptocurrency that you may not fully understand is definitely a way to make you feel a little extra cautious, which isn't necessarily bad. Using a non-custodial wallet does come with some additional requirements for you, but these are relatively simple to manage with a little common sense. If you can handle having some cash in your regular wallet, you likely have the ability to store your keys safely.

A non-custodial wallet will provide you with either a private key, mnemonic seed, or a way to get one of the two; once you have this, it's vital that you store it safely and with the same care you would personal documents. If you lose access to your private keys, you lose the ability to control your funds, and in the case of a non-custodial wallet, there is no way to regain access without them. While this may sound concerning, this is due primarily to the way that traditional banks and other forms of finance have taken a strong custodial role in our lives, but cryptocurrency removes the need for custodians, and all it requires in return is a little care on your behalf.

If you are looking to invest in bitcoin without trusting a custodian with your funds, LocalCoinSwap is an excellent option. When a custodian has control of your funds, often their mistakes can become yours. In many parts of the world, we've seen issues with things like bank runs which bring to the forefront the dangers of custodial relationships in finance. So when you start investing in cryptocurrencies, why not make the most of the power they can provide by being the one in control of your assets for a change.

How Does Non-Custodial Trading Work?

While non-custodial trading is becoming more common among some types of crypto-to-crypto trading, it's less common to find available cryptocurrency on-ramps (places to get in and out of crypto using traditional assets such as cash). You will be able to find a range of decentralized exchanges like Uniswap that offer relatively trustless trading, but finding a place to cash in and out of crypto is something that can be a lot more difficult. However, just as LocalCoinSwap offers non-custodial wallets, it also provides non-custodial trading. Using the platform, you can trade directly from your non-custodial wallets using smart contracts and bitcoin scripts (that are public and open for review) while never giving access to the funds to the platform itself. In the event of a dispute, the funds can be released to one party or the other, but it would not be possible for the platform to take the funds; this is crucial when providing a non-custodial trading environment.

Why Custodial Wallets are Still Common

Custodial wallets do have advantages in some areas, and this is why they are still common. Firstly, these managed wallets allow for internal transactions without the on-chain cost associated with moving funds between real wallets. Using a custodial wallet also removes the need to manage your own keys. Most order book style exchanges outside of DEXs (decentralized exchanges) like Uniswap typically only provide managed custodial wallets. The biggest downside here that you are likely to notice is that a fixed withdrawal fee is usually required, and it will be higher than the typical on-chain transaction. Custodial wallet fees are typically higher due to sweeping transactions which are required to manage funds between hot and cold storage; this helps reduce exposure of funds by moving them into more isolated wallets where they aren't at risk of bugs or other issues the platform could face resulting in a loss of funds. Speed is another common factor that leads to platforms opting only to provide managed custodial wallets. Many centralized exchanges encourage users to make a large volume of trades, and by providing a managed wallet for users, balances can be dynamically adjusted as trades are performed.

Have Your Say on How You Store Your Crypto

While custodial wallets can be convenient in some ways and on some platforms, it's vital to understand you are taking a risk by handing your funds over. When you make a deposit into a custodial wallet, you are giving the responsibility to someone else to manage them for you. It’s up to you at the end of the day whether you are okay with this or not. The most important thing is understanding what you are doing and the differences between custodial and non-custodial wallets and trading.

If you opt for a non-custodial wallet, you retain control of your cryptocurrency at all times, this is a powerful thing and one of the most remarkable features cryptocurrency has to offer; why not take advantage of it.

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