Any crypto-related business that wants to offer a digital wallet to their customers has to start with asking one main question - should that digital wallet be custodial or non-custodial?
The answer to this is essential as the one type they choose will have implications for their end user and for the company itself.
A crypto wallet is not quite like your regular physical wallet you keep in your pocket, nor is it like your online bank account. In fact, digital wallets don’t store physical or virtual money.
What crypto wallets do is store private keys which prove ownership of digital assets, and with those private keys, the user has the ability to manage multiple deposit addresses to buy, sell, and trade on the blockchain.
The question of custodial or non-custodial is focused on who is responsible for the security of the key management.
With a custodial wallet, a user’s private keys are held by a third party such as a crypto exchange or trading platform. The user has to communicate with them to give permission for any transaction.
Binance and Free Wallet are examples of platforms providing custodial wallets. They allow users to hold or trade crypto assets but only after identity verification through KYC processes.
These exchanges are the third-party wallet custodian which essentially means that they have full control over the user’s funds.
It’s both convenient and risky, because on the blockchain, the one who owns the keys owns the coins!
So why use a custodial wallet?
Custodial wallets simplify the process of key management for crypto users making them ideal for beginners on the blockchain. The custodian is the one charged with the security of the private keys, taking the weight of that responsibility away from the users.
They can’t misplace the private keys if they don’t hold them in the first place.
Even if the user were to lose their password to the third-party site, they would have the possibility of resetting it and most custodial wallet providers also feature a higher backup possibility.
The main downside of a custodial wallet is the whole idea of handing over responsibility for private keys, as the cost of this could be huge.
Since custodial wallet providers are generally centralized, they have more regulations to abide by such as KYC (Know Your Customer) and AML (Anti-money Laundering). Users will therefore have to provide ID verification which compromises privacy and anonymity.
Centralized custodians have access to millions of dollars' worth of crypto, making it an attractive target for hackers. Although custodial wallets are hard to hack, it’s not impossible, so there is a higher risk of data breaches.
They can also impose withdrawal limits, charge high fees in order to use their services, and you could lose temporary access to your crypto if the platform crashes.
Non-custodial wallets, also known as self-custody wallets, eliminate the risk of third-party interference, allowing users to be their own bank managers. Non-custodial wallets can be software installed on mobile devices or desktops, or hardware devices that resemble USBs. Some popular examples of non-custodial wallets are hardware wallets like CoolWallet, NGRAVE and Ledger.
Software non-custodial wallets connect to the internet but are encrypted, and require a password to access the private keys. Although connecting to the internet exposes software non-custodial wallets to theoretical risk of data breach or hacking, they are a convenient option for frequent crypto users who need quick access to their assets.
Hardware wallets, also known as cold-storage, are the most popular non-custodial wallets for larger sums of crypto. Hardware wallets store your private keys completely off-chain, meaning there is no risk of it ever being hacked or corrupted. They are known as one of the most secure ways to store your cryptocurrency and the hardest ones to get hacked.
By keeping the responsibility of securing the private key, users of non-custodial wallets maintain full control over their cryptocurrency and digital assets.
This can be especially important for anyone wishing to store large amounts of crypto on exchange accounts. Having complete ownership of their own cryptocurrency can make them feel more comfortable when using your platform.
Non-custodial wallets also give users direct access to the blockchain. By cutting out the middleman, users can withdraw and broadcast transactions instantly. The lack of KYC/AML checks also speeds up the process.
Non-custodial hardware wallets are not connected to the internet for the majority of the time which means they are not accessible to hackers and so the risk of a data breach is significantly lower.
The only real drawback of non-custodial wallets is the possibility of losing the private key which could be financially devastating. As the sole authority, if a user loses their hardware wallet or forgets their pin or password, they could lose access to their funds forever.
While non-custodial wallets generally offer greater security from hackers, they are more difficult to set up which can make them off-putting for first-time crypto users.
Choosing between a custodial wallet and non-custodial wallet is a key decision when it comes to securing cryptocurrency and digital assets for your business, clients or customers.
Custodial wallets are super convenient, but what you gain in ease of use, you lose in control over the private keys and possibly the content of the wallet. Non-custodial wallets do give the users complete control over assets but do not have the peace of mind of a provider's backup.
Ideally, your crypto wallet should be a mix of the two.
There is a possibility of having a hybrid wallet, combining both custodial and non-custodial qualities. This way, the user would have complete control over their digital wallet and funds but can also have backup assistance from a third-party provider.
Crypto APIs can provide you with the best mix of features and functionalities for your specific project. Our Wallet as a Service is a flexible digital custody solution that can be adapted to any type of business using a preferred key management type. It also features military-grade security thanks to the integrated Governance layer and Threshold Signature Scheme with MPC technology.
Our WaaS also allows customers to create an encrypted backup using the RSA public key. In case of an emergency, access to wallet funds is guaranteed using a disaster recovery open-source tool and the wallet backup.
Crypto APIs is a trusted blockchain infrastructure provider that offers a safer way to interact with multiple blockchains. Businesses, enterprises and organizations can launch crypto wallets in a matter of days without the stress and cost of developing blockchain infrastructure from scratch.
To find out more about how Crypto APIs can help future proof your business for the rapidly growing crypto market, contact us today.
This publication is an opinion and is for informational purposes only. It is not intended to be investment advice. Seek a dully licensed professional for investment advice.