What is a self-custody wallet and why is it important?
Self-custody, it’s all about having control over your coins
A self-custody wallet is a type of cryptocurrency wallet where users have complete control over when and how funds are spent. Normally, when funds are transferred out of a wallet, the user must digitally sign the transaction with a private cryptographic key to authorize the transfer.
This is like entering a pin code when using a traditional debit or credit card. Whoever has access to this private information (the pin code) and the card number can make transactions. Similarly, whoever knows your wallet’s private key and public address, could spend funds from the wallet. Therefore, it is important to keep the wallet’s private key in a safe location (such as in a hardware wallet or in an offline storage device) and not share it with others to prevent unauthorized transactions.
On the other hand, in custody wallets, also known as custodial wallets, users depend on a third party to manage funds on their behalf. The private key is in the possession of the third party, who may access and/or spend the funds without the preauthorization of the user. Centralized cryptocurrency exchanges typically use custody wallets to hold customer funds.
Users need to create accounts in the exchange’s platform to view and trade funds. Some benefits of using custodial services include customer support, better user experience, and easier tax reporting. But one should keep in mind that users do not actually have control over any specific coins and need to depend on the reliability of the third party to manage the funds for them. At any time, the third party could declare bankruptcy, as in the case with FTX, or simply disappear with customer funds. This fact has given rise to a popular expression, not your keys, not your coins.
Besides the security that comes with controlling the private key of a self-custody wallet, users can maintain greater privacy than holding funds in a custodial service provider, who may require personal identifiable information (“KYC”) and maintain very detailed logs to have an account with their service. This sensitive information is stored on servers, which could get hacked, potentially exposing customers to scams or social engineering if such private information gets leaked.
Moreover, self-custody wallets are consistent with the aims of having a peer-to-peer, decentralized, digital currency as originally envisioned by Bitcoin’s founder, Satoshi Nakamoto.