Cryptocurrency is experiencing significant volatility, but new opportunities are also always opening up. For example, with the increasing popularity of stablecoins, you can now put them in high-interest accounts and earn competitive passive income and consistent returns.
Before you can invest in crypto in a meaningful way or put it to work, you do need to understand the core concepts that underly this world of decentralized finance.
One big area to make sure you grasp is the difference between a custodial and non-custodial wallet, which is detailed below.
After You Buy Crypto
After you make your first cryptocurrency purchase, you have to decide if you’re going to store it using a custodial or non-custodial wallet.
A crypto wallet is where you keep your digital currency safe but also accessible when you need it. Crypto wallets store your private keys, and they let you send, receive and spend your crypto.
Private keys are passwords providing you with access to your crypto.
In reality, a crypto wallet doesn’t actually store your digital currency because your assets live on the blockchain, but you can only access them with a private key. Your private key proves you own your digital currency, and those keys allow you to make transactions. If you lose a private key, then you lose access to your money.
There are simple wallets and much more complex security options.
A paper wallet refers to a scenario where you write keys on something physical, like an actual piece of paper. Hardware wallets are stored on a thumb drive that you theoretically keep in a safe place, and then if you want to use your crypto, you connect to a computer.
An online wallet is when your keys are stored in software or an app. If you’re using an online app, it should use two-factor encryption, and this creates a system to use your crypto that’s similar to using any other online bank account.
Each general type of wallet has upsides and also downsides. For example, if you use paper or hardware wallets, it’s more difficult for bad actors to access them because they aren’t stored online, but the functions are limited, and they could be destroyed or lost. An online wallet is simple and gives somewhat of a balance between security and ease of access, but your holdings are only as secure as what the wallet provides.
If someone’s going to send you crypto, they could make a transaction to one of the addresses that your wallet’s public key generates. You can share your public key with others, while your private key should stay confidential.
Some wallets also provide options to store non-fungible tokens or NFTs and transfer them.
What Are Custodial Wallets?
The term custodial wallet refers to one where your assets are held in custody.
A custodial wallet means a third party holds and manages your private keys for you. You don’t have full control or the ability to sign transactions, but that doesn’t mean a custodial app is a bad thing.
When Bitcoin first came about, users had to create and manage their wallets and private keys, so they were like their own bank.
With a custodial wallet, if you were to forget your exchange password, you could still access your assets.
While the accessibility and trouble-shooting of custodial wallets are appealing, you also have to think about the services a custodial wallet provides, how the private keys are stored and if insurance coverage is available.
The primary downside of a custodial wallet is simply trusting the funds and private keys to whatever the third party is that you’re using. You, in exchange for that, get peace of mind and convenience.
If you’re going to use a custodial wallet, you have to be careful and make sure you choose a company that’s reliable with a high level of security. You can choose custodians that are regulated.
What is a Non-Custodial Wallet?
A non-custodial wallet means that you retain full possession of your assets at all times. You don’t need to ask permission to use a service, and there’s no approval process. You can download a non-custodial wallet app and start using it right away.
Only you’re going to have access to your funds, which prevents the services provider or a government from dictating how you use your funds.
Taking custody of an asset is a regulated activity, so if you use a centralized crypto exchange, then you are at the mercy of regulators. Cryptocurrency regulations are constantly evolving and shifting, so there’s always that potential risk that you could lose access to your assets based on changing regulatory guidelines.
Exchanges might also charge fees for your to withdraw your assets, and they make the withdrawal process slower.
If an exchange were to get hacked, go bankrupt or dissolve for any reason, you might lose your assets. Crypto exchanges are usually insured, so if the company dissolves, there’s probably no recourse for you.
A non-custodial wallet gives you direct access to public blockchains so you can customize the fees paid to miners and validators.
Since a non-custodial wallet gives you direct blockchain access, they also facilitate interactions with smart contracts so you can gain access to decentralized finance products, earning you passive income.
In exchange for the high level of freedom that comes with a non-custodial wallet is the need for the utmost in personal responsibility. You are holding the private keys entirely on your own, so you need to have practices you follow to protect them.
There’s no answer as to which is better when comparing custodial and non-custodial wallets because it’s going to come down to what your plans are and your goals. The way you want to interact with your crypto assets and the blockchain, in general, is going to guide which type of wallet you use.
If you’re a beginner, you’ll probably start with a custodial wallet, whereas more experienced holders might want to keep their assets in a non-custodial wallet.