Bitcoin wallets are very different to the traditional leather wallet you might carry in your pocket and not just because we’re talking about digital assets. They’re different even compared to traditional digital wallets like what you might use with PayPal or your online bank account number. One of the key differences is what makes it a custodial vs non custodial wallet.
What Is A Private Key
Before we explain the difference between custodial and non custodial crypto wallets, it’s best to first understand what private keys are. A private key is a cryptographic key that gives you access to your bitcoins on the Bitcoin network and looks something like this:
This huge random looking number is obviously impossible for normal people to remember so modern wallets instead use this to generate your Mnemonic Sentence. This is either the 12 or 24 words that most wallets show you and ask you to store in a safe place. The Mnemonic Sentence is most commonly referred to as a Seed Phrase, but it also goes by the names Mnemonic Words, Seed Recovery Phrase or Backup Seed Phrase.
>> Deeper Dive: What Public And Private Keys Are
While most people wrongly believe that their bitcoin wallet “stores their bitcoin” this isn’t true. Bitcoin Wallets do not store any bitcoins! The name “wallet” is used because the creators are trying to make it easily relatable to everyday NPC’s, but in actual fact Bitcoin Wallet software isn’t like a normal “wallet” that might store physical cash or coins.
Instead, Bitcoin Wallets only ever store your private keys which is what gives you access to your bitcoins. Every bitcoin is and always has been located on the Bitcoin network. In summary:
- Bitcoin Wallet: Stores your private keys
- Bitcoin Network: Stores your bitcoins
This might seem like a simple distinction, but it’s a critical one that is very important to understand and embed right from the start as otherwise it leads to lots of confusion. Now that you understand what private keys are and what wallets really store, we can address the original question!
What Is A Custodial Wallet?
A custodial wallet is one where a third party (or custodian) holds the private keys to your bitcoin on your behalf, giving them full control over your funds.
Most custodial wallets are accessed through a web browser just like you might login to your bank or email account. The most common types are ones that are built into Crypto Exchanges so that the user can buy and sell their bitcoin directly from the wallet provider.
This, along with the ability to have the custodial reset your password if you ever lock yourself out do make for some handy benefits to custodial wallets. However there’s significant downsides too.
As the custodian holds your private keys, they can block you from accessing your funds or from transferring them to other wallets just like a bank. They also almost always require you to submit to KYC or AML (Anti Money Laundering) identify verification which then forever ties any bitcoin you buy to your real world identity.
Obviously both of these are the norm for the traditional financial world, but it’s not something that is required when dealing with bitcoin.
What Is A Non Custodial Wallet?
A non custodial wallet (also called a self custody wallet) is one where you hold the private keys to your bitcoin and have full control over them.
Some examples include Sparrow Wallet, Nunchuk, Bluewallet and even Bitcoin Core. While non custodial crypto wallets can come in all shapes and sizes and are even offered by some crypto exchanges like the Coinbase Wallet, they all have the common trait that you and only you hold the private keys to it.
This means that you can take those private keys and send your funds to whomever you want at any time you want from anywhere you want and without anyone else being able to stop you. There are also no KYC or AML tests to pass, meaning it takes literally seconds to download and use. In contrast many custodial wallets can take days to “approve” your account.
As there’s no KYC process, it also means you can transact much more privately. The wallet you download and install has no idea who you are and so cannot link your real world identity to any transactions you make with it.
You can also easily and quickly create 1, 10 or even 1,000 new wallets if you want, all for free and in minutes. Non custodial wallets also allow for more advanced security features such as Multisig or other special transaction types that usually aren’t available to custodial wallets.