Types of Wallets
There are two types of wallets, custodial and non-custodial wallets.
Custodial Wallets
A custodial wallet is a service provider that manages the secret keys, addresses, and payments for you. This means you can view your balance on a nice web user interface, but you are not the owner of the secret keys controlling your coins.
The advantage is that you don’t need to think about securing your secret keys from loss. They come with a recovery mechanism in case the password got lost. It is a bit like your bank account and online banking. But think for a while! In the topic User Verification – Public and Private Keys we learned that everybody who knows the secret key could send coins from the corresponding address. It means that a custodial wallet could simply send your coins to another address. And who says that the wallet actually holds the funds it displays on your screen? Using custodial wallets means trusting a third party. While this is okay for online banking, it poses some serious risks in cryptocurrencies:
- Your custodial wallet provider could be a fraud and if you have enough balance, it just withdraws it and disappears to a beautiful island in the Caribbean.
- This wallet gets hacked, and secret keys get stolen from it. Custodial wallets are worthwhile targets since they own many secret keys. And such hacks happened in the past and will happen in the future.
- Authorities can get their hands on the assets stored in the custodial wallets.
- In the case of a fork, you might not get both resulting cryptocurrencies. (You can read about forks here)
We can summarize this finding:
Your keys, your Bitcoin!
Not your keys, not your Bitcoin!
Non-custodial Wallets
Non-custodial wallets are apps and programs or even little hardware devices which run on your local smartphone or notebook. They create secret keys and addresses for you. You are the owner of your secret keys. This means only you have access to your coins. This is great because you don’t need to trust your key to an unknown third party. But there are also downsides to it:
- You need to make sure not to lose access to your wallet. This means you have to make a backup. It is now solely your responsibility.
- You still need to trust the developers of the wallet app. So, choose wisely, preferably open-source software where people could check that there is no backdoor built-in.
Most of these wallets are “Hierarchical Deterministic wallets” (HD wallets). Such wallets create for every sending and receiving a new address and secret key pair. This helps a bit to improve privacy. The wallet takes care of the secret keys and balances, so you don’t need to worry about this.
Safety First!
Since the wallet is your command and control center and has access to your private keys, it is essential to choose your wallet wisely! There are many fraudsters out there who provide fake wallets that rob you of your hard-earned coins.
And to secure your coins (or rather private keys) from loss, follow the wallet’s instructions meticulously.
