“Not your keys, not your coins.”
If you invest in cryptocurrency it is important to know who has custody of your tokens. And guess what, it might not be you. We have all heard the phrase “not your keys, not your coins”, but what does that really mean?
A Basic Overview
A Custodial Wallet or “hot wallet” is a digital centralized service like an account on an exchange. It is owned by a third party that owes you assets (tokens or currencies). A Non-Custodial or “cold wallet” is decentralized. In this case, only you have access to it.
When opening up a new non-custodial wallet, you’ll generate a unique, alphanumeric Seed Phrase & Private Key which allows you to access your wallet. Because no one else has these, you shouldn’t share them with anyone in order to keep them safe.
A seed phrase is a string of 12-24 random words to your wallet that can be used as a backup in case you lose or forget your password. Using it allows you to restore all of your tokens and information.
There are pros & cons to both custodial and non-custodial wallets
There are pros & cons to both custodial and non-custodial wallets. So it’s important to understand which one is right for what purpose.
Custodial Wallets: Pros
This is the key reason why hot wallets exist. Tokens in custodial wallets are immediately available for use and/or trade.
Custodial wallets are digital wallets offered by centralized third parties, like exchanges, which means they typically run on services and will require no gas or other costs.
Keeping your keys safe is a major concern. With many of these wallets you can even get your passwords to reset or confirm your identity to regain access to your account should you lose them.
4. Customer Service
Being that it’s a service being provided to you, custodial wallets typically come with added customer support to help with whatever trouble you may run into.
Custodial Wallets: Cons
1. You Own Debt Not Tokens Directly
Similar to a bank holding your money, or a casino changing your cash for chips, a custodial wallet owes you tokens. In other words, it holds those tokens and can use them for its purposes in the meantime such as for trading liquidity.
2. KYC and AML Needed
Compliance with Know Your Customer (KYC) and Anti-Money Laundering (AML) regulation is required in many cases depending on applicable jurisdictions and legislations. For you, this means you have to submit an ID to use it and that your transaction history is subject to tax oversight.
3. Data Breach/Hack
Hot custodial wallets of exchanges hold a lot of tokens and Personal Private Information (PPI) which makes them prime targets for malicious actors such as hackers or other attackers.
4. Internet Dependency
To view or transfer your tokens, you need internet access. Being cut from accessing the internet implies being cut from your capital.
Non-Custodial Wallets: Pros
No one else has access to your credentials. No one can spend your money without your unique keys. Not the wallet provider, not the authorities, not the banks. You must authorize every transaction and fee you spend.
2. Lower Risk of Data Breach/Hack
Everyone is a potential target for hackers, just like everyone is a potential target of theft. But being a single wallet with a relatively small amount of tokens compared to what an exchange would hold, reduces your risk of being targeted by attackers.
3. Instant Withdrawals
Having full control means you can move your tokens whenever you want, without any preset delay period imposed by third parties, which are common practices with exchanges.
4. Non-Internet Reliant
Local cold wallets can be accessed without any internet access. And while you may not be able to transact or purchase crypto, you can at least see how many tokens you hold and that they are safe.
Non-Custodial Wallets: Cons
If you make a mistake, you are stuck with the consequences. One typo can mean a loss, and there’s no way of undoing mistakes.
If you lose your password & seed phrase, no one can help you restore your wallet or information. So be very careful!
3. Higher Fees
Fees are based on ETH gas costs, which depend on the price of ETH and the congestion of the network. These fees fluctuate wildly and get pretty high at times.
4. More Responsibility
If it is your first crypto purchase, you may not be comfortable sending funds to a cold wallet or setting one up. Although it is not technically difficult, it can at times be emotionally overwhelming.
Which one is better ?
Many people use a combination of both wallet types
You shouldn’t place all your eggs in one basket, just as you shouldn’t store all your tokens in one wallet. Distributing assets between multiple wallets is a much safer approach. The result of this though is more credentials to remember and keep safe. Find out about best practices to keep your crypto safe.
Fundamentally, it is a trade-off between convenience & security
Custodial wallets are easier to deal with and more convenient if you’re looking to move assets or participate in the markets. But the fear of major problems like attacks should be enough to make one want a second, non-custodial cold wallet to store what you want to keep for the long term.