Custodial Vs. Non-Custodial Wallets: Are Custodial Wallets Safe?

Ben Gehmlich
|
July 10, 2022
With the advent of the Web3 ecosystem, a rapidly growing number of individuals and businesses now recognize the value of digital assets like crypto and NFTs, play-to-earn games etc., and are rushing to own them amid a global transition toward mainstream adoption.

This has put pressure on blockchain startups to help them achieve their dreams as digital assets expand in value. Hence the rise in custodial wallets that make it much simpler for newcomers to manage their blockchain assets.

However, this also brings up the issue of security. The only way digital asset trading can grow and take off is if investors are assured their investments are safe. The future these traders and individuals envisioned rests on safe digital asset custody that meets their requirements. This isn’t an idle concern, as criminals have hacked over $15 billion worth of crypto in recent years.

Let’s dive into how crypto wallets work, their differences, and the importance of private keys in propagating or avoiding user error.

How Crypto Wallets Work

Crypto wallets enable users to interact with a blockchain network and can be used for sending and receiving cryptocurrencies, NFTs, or accessing decentralized applications (DApps). Public and private keys are crypto wallets’ two most essential components. The wallet address is the public key that can be shared so others can send you cryptocurrencies. Private keys are a string of letters comparable to a password that helps users unlock access to their digital assets.

Pros and Cons of Custodial Wallets

Users of custodial wallets allow third parties to manage keys on their behalf. Depending on the provider, some owners don’t get to know or have direct access to their private keys. The advantage of custodial wallets is that when owners forget their passwords, custodians have ways of verifying owners’ identities to enable them to regain access to their digital assets.

Custodial wallets can eliminate cases of lost BTC due to forgotten private keys or lost crypto inheritance due to irretrievable private keys only known to original owners. However, they deny the user the responsibility of securing and remembering passwords besides introducing third parties controlling the wallet’s keys and determining the wallet’s future and contents.

recent admission by the Coinbase CEO that in case of bankruptcy, users’ funds held in custodial wallets on behalf of users would be considered property of the bankrupt company and become subject to bankruptcy proceedings caused a stir in the crypto community on the safety of custodial wallets.

Pros and Cons of Non-Custodial Wallets

Users of non-custodial wallets are responsible for storing and protecting their private keys. Since there are no intermediaries, they have more control over the keys and learn to take greater personal responsibility to protect their keys and seed phrases from theft or loss. The main downside of non-custodial wallets is the ease of use and accessibility, especially for first-time users. Most importantly, users must be aware that they are solely responsible for their private keys and anything that happens to their funds.

The Future of Crypto Wallets

We see the future of Web3 wallets as a blended experience between custodial and non-custodial wallets. Any technology in its early days has to lower the barrier to entry for new users and custodial wallets are a great way to reduce friction for entrants into Web3. Down the road however, the ethos of Web3 and the “not your keys not your coins” idea will grow as users become more accustomed to storing, managing, and securing their private keys.

Looking towards the blended future of Web5, DIDs, and DWNs – where your identity becomes fluid across different platforms and applications – shows a need for non-custodial wallets to truly embrace the ideas of decentralization. In my opinion, however, there will always be users willing to give up some level of ownership for an easier experience; wallets are no different.

A few steps that we advise clients when designing their first web3 offering is to think about:

Onboarding first-time users seamlessly

First-time users of digital products may be familiar with Web2 constructs, such as using your email address to log in. Since Web3 apps demand logging in using digital wallets, allowing new users the time to experiment and familiarize themselves with traditional custodial wallets will help eliminate confusion and suspicion and make them willing to experiment with new apps.

Start with a simple custodial experience

While experienced crypto owners are familiar with private keys and 12-word seed phrases, those encountering them and their impact could quickly get scared. You may want to create an experience they’re familiar with and give them the option of transitioning to self-custody so they can enjoy a broader Web3 experience.

Provide Education Support

Many users interested in Web3 digital products may be unfamiliar with basic security features, two-factor authentication, or password managers in Web2 wallets. Providers must be deliberate in offering user education, so first-time crypto and digital users can have confidence that their assets are safe.

Create a Pathway to a Web3 non-custodial world

Once users unfamiliar with the crypto world get successfully onboard, it will be easy to transition toward self-custody. As they become familiar with processes associated with non-custodial wallets, they will find it much easier to participate in the Web3 ecosystem and seamlessly experiment with new digital products, thus expanding the market for digital product creators.

A Growing Demand for Web3 Access

As we get closer to the eventual evolution of Web3, many platforms are already launching initiatives towards embracing Web3 one way or another. As more providers work towards meeting users where they are and leading them towards new experiences, understanding what your target market is and how they perceive the benefits of web3 can help decide on which wallet offering is best for you.

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