The importance of self-custody wallets has grown tremendously as users explore ways to safeguard their digital assets. The recent fallout of FTX, the world’s second-largest crypto exchange has made self-custody wallets more relevant than ever before. In the case of FTX or any centralized exchange, the private keys of the users are held by centralized entities and as a result, the users risk losing their funds in the case of hacks and bankruptcy threats.
Understanding the difference between custodial (centralized) and non-custodial (decentralized) wallets is crucial as it defines who controls the private keys or passwords to your wallet. Hence, the 2 types of wallets come into play.
To understand private keys, we must first understand what are public keys:
Think of a public key as an email address that you give to send and receive emails.
The private key is like a password to your email address that is needed to verify the transfer of your digital assets.
There is a unique private key associated with every public key also known as the wallet address.
The public key and the private key are both required in unison to conduct transactions on the blockchain.
One must never share their private keys with others as anyone with a private key can have full control of the funds associated with the public key.
Custodial wallets are run by a centralized organization, such as a cryptocurrency exchange. These have some advantages, such as less user responsibility for managing your private keys. However, when a user outsources wallet custody to a centralized company, they are essentially handing over their private keys to that company.
The individual user is not responsible for safeguarding the private key to the wallet and thus relies on the centralized entity to keep the private key secure.
If a user wants to transfer crypto from a custodial wallet, they simply log in with a username and password, enter the public key of the location to which they want to send the crypto, and the centralized company enters the private key to complete the transaction.
This results in a very simple solution for the user to perform crypto transactions, but it also introduces an additional layer of risk to user funds as the company has complete control over user assets. Many exchanges have been hacked in the past, including Mt. Gox, Bitstamp, QuadrigaCX, and BTC-e.
Mt. Gox, a cryptocurrency exchange was compromised several times due to security breaches over the years, the worst being in 2014 which resulted in over $460 million of user’s funds being stolen. Crypto.com, another leading crypto exchange was hacked in 2022 where over $35 million worth of user assets were compromised and stolen.
Because of several exchange hacks in the past, users are becoming more aware of safeguarding their funds. They are moving to other solutions such as non-custodial (self-custody) wallets.
Non-custodial or self-custody wallets are the ones where the user maintains full control of their assets. As a user, you control the private keys to your wallet and retain complete ownership at all times. You do not require any permission to send, store and receive your crypto as no central entity can prevent you from conducting transactions using self-custody wallets.
With non-custodial wallets, no central party can prevent you from undertaking a transaction. The user controls the private key, and hence these transactions are essentially censorship-resistant. Some central entities in custodial wallets can freeze your crypto holdings, set limits on the amount you can transact and even use your assets for their personal gain as was witnessed in the recent FTX case. FTX owners used the users’ assets to fund its subsidiary companies without the user’s consent. Approximately $1 billion of customer funds have been lost from the FTX exchange.
Security is another important aspect one should consider. With self-custody, there is no single point of failure, and thus provides multiple layers of security to your funds. Self-custody not only provides users with ownership rights but also protects powerful actors from corrupting the network and its participants.
On the contrary, custodial wallets store a user’s keys in centralized servers and are more vulnerable to malicious actor attacks and hacks. For example, the $90 million Liquid exchange hack demonstrated the vulnerability of exchange-hosted custodial wallets.
As non-custodial wallet users store their keys in a decentralised way, hackers find it more difficult to steal their funds. Non-custodial crypto wallets are thus paving the future for a safe and secure crypto ecosystem.