This post explains self-custody wallets, which are required to participate in DeFi and how they differ from hosted wallets.
You undoubtedly own a physical wallet or purse where you keep your cash and payment cards. You may even have a digital wallet, such as an Apple Wallet, Google Wallet, Venmo, or PayPal. A self-custody wallet is a place where you store digital money like cryptocurrency and other digital assets. Self-custody wallets, also called non-custodial wallets, are required to transact with blockchain-based financial applications, such as the Compound Liquidity Pool and other DeFi applications.
Self-custody wallets work differently from everyday wallets
To participate in DeFi to earn interest or invest in more complex fixed-income products, you need digital money like digital dollars USDC, DAI, or other cryptocurrency. But you can’t store those in your Apple Wallet. You need a self-custody wallet.
Self-custody wallets actually store “private keys” that allow you to securely access your blockchain-based assets, such as cryptocurrency Bitcoin and Ether. Each private key corresponds to a public key, also known as the wallet address. The pair of public and private keys are used together to transact on blockchains. This pair is unique, and most self-custody wallets generate them using special algorithms.
Why are the keys needed? The public key acts as an identifier for your account on the blockchain network. Think of it like an email address that you share. You receive funds by telling someone your wallet address (public key).
The private key, on the other hand, is used to sign and approve the transfer of digital money, which is like the password for your email. Only the wallet owner has access to the private key. Passwords and private keys must be securely stored and not shared with anyone. A private key corresponds to your public key and is used to confirm that your funds belong to you. Transactions on a blockchain can take many forms in DeFi: sending digital money, depositing digital dollars to Compound Liquidity Pools, and accessing services like borrowing, investing, and trading.
Why are they called “self-custody” wallets?
Self-custody signifies that only you have the possession of your digital money or other digital assets because you control the private key. You have the responsibility to safeguard access to your private key because it is not stored anywhere else. You have access to your funds 24x7x365 instead of relying on a financial intermediary. This flexibility allows you to participate in DeFi.
You don’t usually need technical knowledge to use a self-custody wallet
Using a self-custody wallet is straightforward. It’s just like using a regular investment or payment app with additional security measures. You can use this interface to check your balance, view your transaction history, invest using DeFi applications, and send digital money to your friends. You can even link your self-custody wallet to your bank and deposit digital money to the Compound Liquidity Pool – something Linen App provides to its members.
Types of self-custody wallets
There are several different self-custody wallets. They differ based on how they work and the way they provide access to your digital money.
Mobile wallets are apps on your iOS or Android phone, so they are convenient because they are always with you. Usually, the private key is generated and stored on your device with backup and recovery options, depending on the app.
Smart contract wallet
A smart contract is a program that is deployed to the Ethereum blockchain and has a mobile app or desktop interface. Smart contract wallets are the most functional wallets because they can be programmed in many ways and have additional security measures like daily spend limits, further approval from a trusted party or another wallet if transactions are above a certain limit, and advanced recovery mechanisms. Private keys are generated on the mobile device or browser.
Hardware wallets are separate physical devices built to securely store private keys and approve transactions. They usually look like a thumb drive or thick credit card. You can link a hardware wallet to a computer and use a desktop-based app to transact. Hardware wallets are known for their security because the private keys are never exposed to the internet.
Desktop wallets are installed on laptops or desktop computers. They are typically more complex than their mobile-based versions. Desktop wallets are not as convenient as mobile wallets, although they provide good security. Private and public keys are generated on a desktop device.
Paper wallets aren’t exactly high-tech, but they offer excellent security nonetheless. As the name suggests, paper-based wallets are a physical paper copy or printout of your public and private keys. When you need to transact, you type in your keys or scan the paper. You can input the public and private keys using web-based applications.
Are self-custody wallets secure?
Self-custody cryptocurrency wallets are as secure as how well you keep your private key safe. A combination of software, hardware, and common security measures, such as physical access to your wallet, keeps your wallet secure. Do not share access with anyone, and keep your phone locked at all times if you use a mobile wallet. Additionally, use a separate passcode to lock your mobile wallet application if you can.
Can a self-custody wallet provider access my funds?
Self-custody wallet providers cannot access your funds, even if they make the wallet because the private key is generated on your device and is accessible only by you. Even if the provider stops supporting the wallet or goes out of business, your funds are still in your possession if the wallet backup and recovery mechanisms are in place.
Are there non-self-custody wallets?
Yes, some wallet providers maintain control of private keys on their servers and transact on blockchains on behalf of their users. These wallets are called hosted or custodial wallets. That means you don’t have to worry about the security of your private key personally, but rather entrust it to a financial intermediary. Private keys for hosted wallets are stored in one location, and this makes it a tempting target for hackers. These wallets can and have been hacked like the Mt. Gox Japanese Custodial exchange losing $450 million in 2014.
Hosted wallet providers are limited in the services they can provide, which is usually buying and selling cryptocurrency. Coinbase is an example of a hosted wallet provider. You cannot participate in DeFi using hosted wallet providers today.