Did you know that you don't have to give up control of your crypto just to trade?
Do you ever get nervous leaving your crypto on a centralized exchange that only offers custodial trading? Maybe you’ve wondered if you can really have your own secure wallet that works directly with an exchange? Find out why non-custodial trading may be the answer to trading securely and without having to worry about who has control over your cryptocurrency.
What is a Custodial Exchange?
A custodial exchange requires you to hand over control of your cryptocurrency to trade or otherwise use the platform. The wallets are typically managed, wallets which means they are operated and controlled by the exchange operators. If you're ever used a cryptocurrency exchange that allows you to buy or sell using your local currency, the odds are very high you've used a custodial exchange in the past. Even many of the older P2P marketplaces operate as completely custodial platforms.
While custodial platforms have their uses, it's important to understand there can be some risks when using them that you may not have considered.
Centralized Custodial Exchange Advantages
- Less responsibility as there's no need to secure your own keys
- Trades can be completed faster as they don't require on-chain transactions
- You can likely reset your password if you forget it
Centralized Custodial Exchange Disadvantages
- Third-party risk as the platform holds your funds
- It's hard to verify a fully custodial exchange is solvent
- Hacks can result in a loss of funds that are passed onto users
What is a Non-Custodial Exchange?
Opposed to a custodial exchange that requires control of your funds, a non-custodial exchange allows you to trade without handing over your funds to a third-party and the ability to maintain control over your private keys. If you are the only person with access to your private keys, only you can choose what happens with your funds, and this is one of the reasons non-custodial exchanges can be extremely secure to use.
If you're looking to use payment methods outside of a standard bank or wire transfer, a non-custodial bitcoin exchange that supports P2P trading can be a fantastic choice. P2P trading is a great way to exchange bitcoin and other popular cryptocurrencies using otherwise unavailable payment methods, even cash.
What are the Benefits of Using a Non-Custodial exchange?
- Retain control of your funds and private key or account mnemonic to generate them
- Little to no third party risk as your funds aren't exposed to managed hot wallets
- Non-custodial exchanges tend to be more private overall
What are the Downsides of Using a Non-Custodial Exchange?
- Non-custodial trades typically occur on-chain, so they can be slower
- If your wallets are non-custodial, often password reset is not possible
- Should the platform go down before you back up your wallets, you couldn't access them
Are Decentralized Exchanges Non-Custodial?
While almost all decentralized exchanges can be considered non-custodial, not all non-custodial exchanges can be regarded as decentralized. Furthermore, while decentralized is a great word, its meaning has been softened a little in recent years as the term has often been used quite broadly. In short, the thing to remember is that non-custodial doesn't mean decentralized, these are different terms, and while they usually fit together well, that isn't always the case.
How does Non-Custodial Trading Work?
While this can vary, there are some commonalities that you can expect to see in most cases. If a platform offers non-custodial bitcoin trading, they will likely be using bitcoin scripts or forms of multi-signature transactions where multiple parties have to sign a transaction.
In the case of cryptocurrencies like ethereum, where they support smart contracts, these will often be used to provide on-chain trading. While a growing number of cryptocurrencies support the ability to be used for non-custodial trading, unfortunately, only a limited number of non-custodial exchanges have arisen to provide it. At least when it comes to trading for local currency and other payment methods aren't purely crypto-to-crypto.
For a basic example, three participants are usually involved in a non-custodial trade: the buyer, the seller, and the arbitrator/moderator. In a non-custodial trade, the seller would need to fund the escrow, whether by funding a specific type of wallet, performing a particular transaction, or interacting with a smart contract designed for the task. The arbitrator should only have access to release the funds to either party and not take control of the funds themselves, and their role is purely to step in during a trade dispute and decide who is the correct owner of the crypto. Generally, a small fee is taken for their service.
In a crypto-to-crypto trade that is non-custodial, a smart contract can remove the need for an arbitrator as both payments can de dealt with on-chain. The difference in other types of trades (commonly non-custodial P2P trades) is that one of these payments can't be verified on-chain, so disputes can naturally arise. However, due to the restrictions typically imposed on the arbitrator, they couldn't seize the funds, so they don't pose a third-party risk in a conventional trade whatsoever.
Non-custodial trades leverage the blockchain networks themselves to provide the infrastructure for trading with minimal third-party risk. It is a modern and interesting way to approach safe trading, something that has even been important long before the existence of cryptocurrencies.
Which are best, custodial or non-custodial exchanges?
The type of exchange best suited to you should come down to your specific situation and preferences. If both types of exchange would do the job you need well in your case, it's always worth opting for the non-custodial choice. However, if you require instant crypto trades or only a custodial platform offers a specific trading pair you are looking for, that may be the better option for you in that situation, provided you take into account the potential risks. It's also worth noting that while non-custodial trading can be slightly slower, this depends mainly on the cryptocurrency being used, its block times and if a sufficient fee when making necessary transactions.
Suppose you want the benefits of non-custodial trading but want to avoid volatility. In that case, one of the best ways to do so is by trading stablecoins for your payment method of choice on a non-custodial P2P exchange.
What You Should Know About Non-Custodial Exchange
One of the most important things to remember when using a custodial exchange is that you are giving over control of those funds to someone else every time you make a deposit. Unfortunately, a common mistake people make is treating custodial platforms as banks for their entire cryptocurrency portfolio. Over the years, several custodial platforms have suddenly been shut down or become insolvent due to hacks, poor management, or even legal action that can result in you losing control of your crypto before you've even realized what's happened.
If you want to embrace the true strengths of cryptocurrency, consider using non-custodial exchanges whenever possible, taking your privacy seriously, and always making sure your private keys are only for you to see!