Custodial vs. Non-custodial Wallets | All You Need to Know

When it comes to choosing a crypto wallet, you have two main options: custodial or non-custodial. But what are the differences between them? And which is right for you? In this blog post, we will explore the pros and cons of each type. Our team spent countless hours researching the topic to write this guide. At the end of it, you will understand how custodial and non-custodial wallets work, and you will be able to choose the best solution for your needs. 

In This Guide: 

How Crypto Wallets Work: Understanding Public & Private Keys

To understand the difference between custodial and non-custodial wallets, it is important to first understand how crypto wallets work. The most critical thing to understand is that at the core of every wallet is a set of what are known as public and private keys.

Your public key is like your bank account number—it is what you give to people so they can send you crypto. To be more precise, the public key is an incredibly long string of characters. To make things easier, crypto wallets shorten the public key and give you a public address that you can share with other people to receive crypto assets.

On the other hand, your private key is like your password—it is what you use to access and spend your funds. Crypto scammers are constantly trying to steal users’ private keys via phishing emails, fake websites, and other scams. That’s why you should be very careful and never share your private key with anyone as it gives them full access to your funds. 

With this in mind, let’s take a closer look at custodial vs. non-custodial wallets. 

What is a Custodial Wallet?

A custodial wallet is one where the private keys are managed by a third party—usually a crypto exchange like Coinbase or Crypto.com, through which you can buy and store crypto without worrying about managing or losing a private key.

Custodial wallets work similarly to a bank or other financial institution. They have access to your private key and store your crypto assets for you. Hence, they have full access to your funds and work as an intermediary between you and other wallets. 

As with a bank account, you can open a custodial account by submitting personal documents, such as your ID card and bank statements. With non-custodial crypto wallets, your private key is the only way to prove ownership of your crypto. Instead, with custodial wallets, you do so using your identification documents. 

Custodial wallets are easy to use and require little personal responsibility for storing the private keys, but if their database gets compromised, all your funds are lost forever. This has happened many times in the past. 

Indeed, a total of nearly USD $2.58 billion has been stolen from crypto exchanges since 2012, with 46 exchanges compromised. And this is why so many people prefer a non-custodial wallet over a custodial one. But we will get deeper into the pros and cons of each later in the guide.

chart: crypto stolen from crypto exchanges

Source

What is a Non-Custodial Crypto Wallet? 

Non-custodial crypto wallets (also known as self-custody wallets) are a type of cryptocurrency wallet where only you, the user, control the private key. This means that only you have access to your crypto assets and no one else.

Usually, a private key is a long string of hundreds of numbers and letters mixed, impossible to memorize. However, many crypto wallets simplify them into about a dozen unrelated words that you must write in order. So when you download a non-custodial wallet, it will give you a list of 12 to 24 words like the one below:

screenshot: non-custodial wallet seed phrase example

This list is known as a seed phrase, from which the wallet will be able to derive your private key. 

Different types of non-custodial wallets are available on the market, with the main distinction being between hardware wallets (also known as cold wallets because they are not connected to the internet) and software wallets (also known as hot wallets), which are mobile or desktop apps.

In any case, to gain access to your funds, you have to remember your seed phrase.

Let’s say that you’ve lost your phone where you had your crypto. You can recover the wallet by downloading the app again and inputting your seed phrase. 

This is usually the only way to recover your non-custodial wallet if you lose it. That’s why it’s extremely important to never lose your seed phrase. You can save the key on a device or write it down. If you forget it, you could lose access to your funds forever. 

At the end of the guide, we will explain the best way to use a non-custodial wallet without ever worrying about losing your seed phrase, and thus losing access to your funds forever. 

Custodial vs. Non-Custodial Wallet: The Main Differences

Now that we know the basics of how custodial vs. non-custodial wallets work, let’s recap and take a closer look at the main differences between them. 

1. Private Key Custody

Private key custody is almost always at the center of the most heated debates about which wallet is better: custodial vs. non-custodial.

Custodial crypto wallets hold and administer your private key for you. Hence, they have full access to your funds and work as an intermediary between you and other wallets. In the common world, a good metaphor for a custodial wallet would be a bank or other trusted institution.

This differs from non-custodial wallets where you need to store the private key yourself. This can be done by saving the key on a device or by writing it down. However, these two options are both risky because if you lose or someone steals your seed phrase, your funds are lost forever. We’ll see later how to get a non-custodial wallet without worrying about that.

2. On-chain Transactions

When it comes to custodial wallets, it’s important to understand that transactions don’t happen directly on-chain but off-chain. 

To put it simply, if you sell some Bitcoin to get some Ethereum using a crypto exchange, you won’t find that transaction on a blockchain network. Instead, the crypto exchange will simply update its database to reflect the fact that you now own different amounts of crypto. So instead of happening on the blockchain, transactions happen internally.

On the other hand, transactions through non-custodial crypto wallets happen directly on-chain. This means that when you make a transaction, it is recorded on the blockchain.

3. Wallet Backup and Recovery

If you lose access to your custodial account, you can usually recover your funds by contacting the customer support team of the exchange or service that you are using. As with a bank account, they can help you recover your account by checking your ID documents to verify that you are the real owner of the account.

With a non-custodial wallet, however, you are responsible for backing up and recovering your own funds. This can be done by storing your seed phrase in a secure location. If you lose your private key, there is no customer support team that you can contact to help you recover your funds.

4. KYC

KYC (an acronym for know your customer) is a regulation that requires financial institutions to verify the identities of their users and conduct additional check-ups. In simple terms, it is the process of going through your ID documents and confirming that you are who you say you are.

Custodial wallets are subject to KYC compliance. This means that when you sign up for a custodial wallet, you will usually be required to provide some form of identification such as your driver’s license or passport.

Non-custodial wallets are not subject to KYC compliance, so you are not required to provide any personal information when setting up the wallet.

Infographic: custodial vs non-custodial wallets

Custodial Wallets: Pros & Cons

If you are considering using a custodial wallet, it’s important to understand both the pros and cons of this type of wallet.

Custodial Wallets: The Pros

No Risk of Losing Your Seed Phrase

As we mentioned earlier, you don’t have to memorize a seed phrase for custodial wallets, and you can usually recover your funds by contacting the customer support team of the exchange or service that you are using. There is no risk of losing your seed phrase because there isn’t any seed phrase to lose or forget.

Backup & Recovery Options

Another advantage of custodial wallets is that they usually have backup and recovery options. If you forget your log-in details, the wallet can help you retrieve your password and log you in, as long as you can prove your identity. 

Ease of Use

Another advantage of custodial wallets is that they are usually easy to use. They require considerably less effort to manage and carry out transactions than non-custodial wallets. 

The ease of use of custodial wallets makes them more appealing to beginners. If you are just getting into crypto investing, you will find custodial wallets to be more straightforward than non-custodial wallets.

Custodial Wallets: The Drawbacks

Not Your Keys, Not Your Crypto

“Not your keys, not your crypto” is a common saying in the crypto space that means that if you don’t have control of your private key, you are not entirely in charge of what happens to your crypto assets.

If you use custodial wallets, the institution reserves the right to perform any action on your account. For example, in January 2022, Binance froze the accounts of 281 Nigerian users in compliance with “international money laundering laws.” So far, they have only restored 79 of those accounts.

With custodial wallets, you don’t have full autonomy of your account because you don’t have access to your private key.

Another problem with leaving control of your keys to a centralized exchange is that they are prone to losses due to corrupt practices and embezzlement. No example proves this better than the story of Gerald Cotten and QuadrigaCX

During the crypto boom of 2017, QuadrigaCX was the biggest Canadian custodial exchange with over 350,000 users and hundreds of millions of dollars in transactions. However, after the crypto boom, there was a crash that uncovered many unforeseen secrets.

People discovered that the exchange was an elaborate Ponzi scheme. Moreover, Cotten alone held the private keys to many cold wallets containing hundreds of millions of users’ assets that they never recovered.   

Cotten died in late 2018, and about $200 million worth of crypto assets followed him to the grave.

Need for KYC

Another disadvantage of custodial wallets is KYC compliance. This can be a drawback because it means that you need to provide your personal information and identity documents and wait up to 72 hours for them to be verified. So this is a pretty long and tedious procedure and you will need to wait for it to be completed before using the service. 

Waiting Time

Numerous custodial wallets have something called a “holding period.” The issue is that you must wait a certain amount of time after purchasing a cryptocurrency before you may send it to another crypto wallet or withdraw it back to fiat. This period can last up to three days, depending on the platform. 

The goal here is to safeguard both your account and the platform itself from malicious activity. However, you can see how inconvenient it is in terms of speed, not to mention the additional security checks that slow down the process even more.

High Risk of Hacking and Data Breach

Huge amounts of private data maintained by custodians, particularly private keys, are a tempting target for hackers. As a result, we regularly hear of crypto hacks and data breaches.

As already mentioned, a total of nearly USD $2.58 billion has been stolen from crypto exchanges since 2012, with 46 exchanges compromised. A good example of a recent crypto hack is the 2020 KuCoin Hack. In this case, the hackers made away with over $280 million worth of crypto from the exchange, affecting many users.

screenshot: KuCoin Custodial Accounts Hack

In addition to your crypto, personal data such as your name, address, and date of birth can also be at risk if a custodial crypto wallet is hacked. This can leave you susceptible to phishing attacks and identity theft. Unfortunately, data leakage is nothing out of the ordinary either. In February 2021, hackers obtained thousands of users’ email addresses, passwords, and trade details in the KeepChange data breach. 

We could go on and on about different attacks, but as you can see, security is a significant issue for custodial wallets. Considering these disadvantages, custodial wallets appear to be a poor solution for storing crypto securely. 

Non-custodial Wallets: Pros & Cons

Like custodial wallets, non-custodial wallets also have both advantages and disadvantages that you should be aware of.

Non-custodial Wallets: The Pros

Full Control of Your Crypto

Perhaps the most important advantage of using non-custodial wallets is that you have complete control of your crypto because you have possession of the private keys. This means that you are in full control of your crypto and no one else can access it.

As a result, you are fully responsible for the safety of your crypto, and you have full autonomy over your assets.

With non-custodial wallets, you don’t have to trust a centralized institution to keep your keys and assets safe. This means your funds are not at risk of embezzlement or corrupt practices.

No Need for KYC

With non-custodial wallets, you don’t need to verify your identity with government-issued IDs or passport photographs. When KYC isn’t required, there’s more room for crypto’s essential values: decentralization and privacy. Users retain their sensitive information. Furthermore, because there is little to no information for hackers to steal, the risk of data leaks is minimized.

No Transactions Limitations

Most custodial wallets require you to wait anywhere from 24 hours to a few days for withdrawals to be processed. Instead, transactions in non-custodial wallets usually are unrestricted in terms of size and speed. There is no holding period, and your assets cannot be frozen or limited in any way, as often happens with custodial wallets.

Non-custodial Wallets: The Drawbacks

User-friendliness

Non-custodial wallets are usually a bit more complicated and less user-friendly than custodial wallets. This is because in order to utilize a non-custodial wallet, you must have a basic knowledge of how crypto wallets work. 

Backup & Recovery Options

Another key point to consider is that non-custodial wallets generally have fewer backup and recovery options than custodial wallets. This is because you are solely responsible for backing up and recovering your crypto wallet. Losing your private keys would mean losing access to your wallet and all of your funds.

So…What Wallet Should You Choose?

As you can see, both custodial and non-custodial wallets have advantages and disadvantages. Custodial wallets are generally easier to use and have many recovery options if you lose access to your account. On the other hand, they don’t allow you to have complete ownership of your crypto, which goes against the entire premise of cryptocurrency and blockchain technology. Furthermore, the huge amount of crypto owned by custodial wallets makes them a tempting target for hackers, with billions in crypto already stolen.

Considering all of that, we must admit that we are not big fans of crypto exchanges and custodial wallets. On the other hand, we recognize that non-custodial wallets might be difficult to use for crypto beginners. Furthermore, the main problem with non-custodial wallets is that if you lose—or someone steals—your seed phrase (the 12 to 24-word password to access and recover your wallet), you’ve lost your funds forever. 

However, you should know that not all self-custody wallets are created equal and that there is a new generation of wallets that solve this problem—I’m talking about smart wallets.

Smart wallets are a new type of non-custodial wallet that offer all the benefits of non-custodial wallets while also allowing you to back up and recover your wallet without worrying about a seed phrase. And that’s why, at Linen, we’ve decided to build exactly this type of wallet.

So how can smart wallets like Linen be so secure while also being much easier to use and recover? Let’s get deeper:

  • Multi-keys: Linen Wallet is secured using three keys, not just one like most non-custodial wallets. Two out of the three keys are required to make a transaction. As such, even if you lose or someone steals one key, you are still in control of your funds. Other non-custodial wallets only have one key, and if you lose it or someone gets access to it, all your funds are lost forever.
  • Easy wallet recovery: One of the main problems with other non-custodial wallets is that you have to store your private key yourself on a piece of paper or metal card. As such, the risk of losing it is very high. Instead, Linen Wallet makes it easy to manage your private keys—one key is stored in your cloud, one in your mobile device, and one in Linen’s secure server infrastructure, so you can seamlessly recover your wallet using your cloud drive, email, and phone number.

We might be biased, but we truly believe this is the most secure and easy-to-use option if you want to have full control over your crypto while also being able to easily back up and recover your wallet. 

You can download Linen Wallet on the Apple App Store or join the waitlist for the Android version that will be released soon. And if you have any questions, you can always reach out to support@linen.app. We usually reply within one business day and are always happy to help!