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In this episode of BeInCrypto’s Video News show, host Juliet Lima explains the difference between custodial and non-custodial crypto wallets.
When people buy their first cryptocurrency, they often have some immediate questions. What type of crypto wallet should I use? Am I storing it correctly? Will someone hack me? Can other people hold onto the crypto for me so I don’t have to take all the responsibility? All of these are valid questions, which can be answered with an understanding of custodial and non-custodial wallets.
Custodial or non-custodial
Cryptocurrencies are stored in something called a wallet, which is actually where public and private keys are stored. A public key is an address associated with your wallet which can be publicly viewable. This is a string of letters and numbers where one can receive funds sent to the wallet.
As you may surmise, a private key is something a little bit more personal. Whoever controls the private key for the wallet also controls the funds, as the private keys are what allow for money to be sent out of the wallet.
A wallet’s private keys are stored as something called a seed phrase. It’s a cryptographically generated list of words, usually 12 or 24 of them, that corresponds with the private keys for that specific wallet.
The seed phrase can be used to regenerate the wallet if the device is ever lost or stolen. It’s important to remember to keep the seed phrase safe, as whoever controls this effectively controls the coins in the wallet.
This is where the idea of what type of wallet you choose becomes important. Custodial wallets enable someone else to have custody of the private keys of the wallet, whereas non-custodial wallets allow individuals to retain control of their private keys.
Hot and cold crypto wallets
There are different types of non-custodial wallets, with hot wallets and cold storage wallets being the two main types.
A hot wallet is a non-custodial wallet that is connected to the internet. These wallets are usually apps on cell phones or other devices, but as they are connected to the internet, they remain under constant threat of attack. It would be wise to only keep a small amount of crypto in it, such as everyday spending amounts.
The other type of non-custodial wallet are known as cold storage wallets, which use something called a hardware device. They are called cold storage because they stay disconnected from the internet. Trezor and Ledger are two of the most popular brands offering these devices.
This type of storage is really only recommended for holding a fairly large amount of cryptocurrency, as they are moderately priced. It is theoretically safer being disconnected from the internet, but this also makes it a little more inconvenient to access funds. That inconvenience is offset by the added safety of storing the crypto offline.
As non-custodial wallets allow for individuals to have complete control over their crypto, they come with the onus of personal responsibility. Individuals must determine how to properly back up their seed phrase and keep it safe from any unforeseen disaster. If done wrong, all funds could be lost.
Custodial wallets
Meanwhile, with custodial crypto wallets, the responsibility for security is now foisted upon the wallet provider. They have the private key to the wallet, and with that ownership of the private key,
they control the funds associated with that wallet. They must be trusted with the security of the wallet and to give you back the funds when asked for.
With all the funds in one place the custodial wallet operator has now created a huge incentive for hackers. With such high rewards for the successful hacking of a custodial wallet, there have been numerous such instances. Unlike a bank, which may be insured with the FDIC, many of these custodial wallets have no way to pay back users if their funds are stolen.
Also, those in charge of the wallet might be potential threats as well. Given the proper incentive to abscond with the funds, they just might try to get away with it. Either by outright stealing it, or maybe trying to claim it as being lost or stolen. Unfortunately, any legal recourse has usually been signed away when upon agreement to the terms and conditions of using the custodial wallet.
Which is the better crypto wallet?
Considering which is preferable comes down to several factors. How much crypto do you have? How responsible are you? Do you feel comfortable trusting other people? Do you know what you’re doing when sending and receiving crypto? These are just a few of the things to consider when deciding whether you choose a non-custodial or a custodial crypto wallet.
Perhaps an ideal solution would be a combination of both. Users ready not up for the challenge of keeping their secret seed phrase stored securely, should just opt for custodial wallets. While keeping funds in a custodial wallet, users could also work on learning more about storing their crypto, so they can one day opt for a non-custodial wallet.
For non-custodial wallets, multi-signature wallets are also another option. These are wallets where numerous private keys must be entered in order to move the funds. For instance, with a 2 of 3 multi-signature wallet setup, one would need 2 of the 3 keys to spend the funds from the wallet. These keys could be stored on hardware devices to increase security even more.
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