Wallets: custodial, non-custodial, self-custodial. What does that mean and which one do you need?

To use Bitcoin you need a Bitcoin wallet. If you start looking for one, you will soon come across all kinds of terms: custodial, non-custodial, self-custodial. What does that mean and which one is best for you? You can read that in this article.

If you want to start with Bitcoin, you need something to store and manage your bitcoins: a bitcoin wallet. That is a kind of virtual wallet for bitcoins.

Bitcoin wallets come in all shapes and sizes, but there are two fundamental underlying differences that it is good to be aware of. In this article we explain the difference between a self-custodial wallet and a custodial wallet .

Bitcoin wallets

For convenience, you can compare a bitcoin wallet to an e-mail account, but for Bitcoin. Just like with e-mail, you can manage a bitcoin wallet in all kinds of ways: via a website, via an app on a phone, via a program on a computer, and so on.

There are also other and more fundamental differences. With e-mail, for example, it is different when you use e-mail from a service provider than e-mail where you run your own mail server. Service providers also differ from each other, because a free email account is not quite the same as an email address that you pay for. There are also such fundamental differences with Bitcoin.

Email may not always be important, but Bitcoin is. After all, Bitcoin is not a digital post, but digital money, and that almost always makes it important to be critical.

Custody: self-custodial, non-custodial, custodial

To what extent do you want to entrust your bitcoins to others? That is the core question at issue.

Basically, Bitcoin is a decentralized network in which participants are completely autonomous and sovereign, but participation does require a certain responsibility, knowledge and skill. Service providers can take a lot off your hands and simplify things, but they introduce other risks and disadvantages.

To indicate the differences, a distinction is made between two types of bitcoin wallets: self-custodial (or non-custodial ) wallets and custodial wallets. The English word ‘ custody’ means something like ‘to manage’ or ‘to take into custody’. A ‘ custodian ‘ is therefore a service provider who acts as an intermediary as a kind of ‘custodian’, ‘guardian’ or ‘administrator’.

Self-custodial & non-custodial bitcoin wallets

If you want to participate in the decentralized Bitcoin network yourself on the basis of complete autonomy and sovereignty, a self-custodial wallet is the right choice. A self-custodial wallet is the most traditional and normal kind of bitcoin wallet out there.

seed phrase

The seed phrase is like a password for your bitcoin wallet. It is a series of 12 or 24 English words that you basically get once when creating a new self-custodial bitcoin wallet. If you don’t get a seed phrase it is probably not a self-custodial wallet but a custodial wallet.

Sometimes people also speak of non-custodial wallets, but that gives the impression that it is a different type of wallet, while the opposite is the case. The two terms are used interchangeably but mean the same thing: that you control the seed phrase yourself .

The seed phrase is the basis of the sovereignty that Bitcoin offers: as long as you alone have the seed phrase, you are the only one who can do something with your bitcoin wallet. Therein lies the strength of Bitcoin, but also a risk. Protecting the seed phrase is essential, because if you ever lose the seed phrase or it is stolen, you could lose your bitcoins and no one can help you.

With a self-custodial bitcoin wallet you have full control: the bitcoins in your wallet are yours and only you have the seed phrase that gives access. There is no service provider or third party involved and transactions go directly from you to the recipient.

This provides a lot of freedom, but also responsibilities. After all, if something goes wrong, you are on your own and there is no service provider to help or protect you. So with a self-custody you have to pay close attention and have some knowledge.

Are you new to Bitcoin? Then try it out with a small amount first. If you are a bit smart and familiar with computers and the internet, a self-custodial wallet is within reach. The most important thing is that you understand a few basics and are able to store and protect 12 or 24 words safely and offline (make an extra backup!).

However, if you consider yourself not very computer savvy, ask yourself if you can handle the responsibilities and risks. A custodial wallet can be a bit more accessible in some cases.

Advantages

  • Sovereignty
  • Autonomy
  • No dependencies
  • No counterparty risk (counterparty risk)
  • Peer to peer transactions
  • Censorship resistant
  • Unconfiscable
  • More technological gadgets
  • Privacy Benefits

Cons

  • Own risk and responsibility
  • Some basic knowledge and skills required
  • Take care of securing the seed phrase yourself
  • If the seed phrase is lost or stolen, you can lose everything
  • No option to reset or request the seed phrase again
  • No helpdesk or support department

Custodian wallets

The counterpart is a custodial wallet. These are bitcoin wallets that are managed by a service provider. These are often websites where you can log in on the basis of traditional accounts. It can be a web wallet but also an exchange. Sometimes they are also apps or programs. So they come in all shapes and sizes.

seed phrase with a custodial wallet . With a custodial wallet you don’t actually have a real bitcoin wallet. Only the service provider is connected to the Bitcoin network and has a real Bitcoin wallet with a seed phrase. They manage the bitcoins on behalf of their users and you can indicate via their website or software where they should send them. Do you have bitcoins but no seed phrase? Then you probably use a custodial wallet.

Custodial wallets work a bit similar to traditional banks or payment platforms such as PayPal. As a user, you log in to your account where you can make transactions, but the actual movement of the money is done by the service provider.

With a custodial wallet, most of Bitcoin’s innovations are lost. After all, Bitcoin is revolutionary because no intermediaries are needed. This is where most of Bitcoin’s unique properties stem from. With a custodial wallet you reintroduce an intermediary, which undoes many advantages. Pretty much all that’s left is the scarcity of up to 21 million bitcoins.

A custodial wallet is not necessarily more secure than a self-custodial wallet. On the one hand, service providers simplify use and take on some of the security, but on the other hand, they also introduce disadvantages and risks that you don’t have with a self-custodial wallet.

Is such a service provider actually reliable? Aren’t they scammers? What if there is bankruptcy? What about privacy? What about the legislation? Are they really good at security? What if they get hacked? Unfortunately, the latter does not happen infrequently. Be careful who you hand over your bitcoins to, because once you transfer them to a service provider, you depend on them to get them back.

Two-factor authentication

A username and password are usually easier to crack than a seed phrase of a self-custodial bitcoin wallet. Therefore, preferably protect your custodial wallet account with Two-Step Authentication (2FA) as an extra layer of security.

A custodial wallet can be interesting if you know that you have very little knowledge of computers and the internet, but still want to invest in bitcoin. You may miss most of the benefits, but if you only care about the investment opportunity and if you understand and accept the risks, a custodial wallet can lower thresholds.

Custodial wallets are also sometimes used as a ‘hot wallet’ where you don’t put all your savings, but only a small amount for daily spending. Since the amounts are small, the risks are less objectionable and sometimes it is more user-friendly.

Accounts at exchanges, brokers or other websites where you can invest and trade in bitcoin are almost always custodial wallets. Preferably use these types of services temporarily for trading, but not for long-term storage because exchanges are regularly targeted by hackers.

Always do proper research into the service provider and preferably choose a party with a good reputation from an EU country.

Advantages

  • Traditional and well-known method
  • More accessible and sometimes simpler
  • You don’t need to secure a seed phrase
  • The service provider manages the bitcoins and the actual bitcoin wallet
  • Sometimes opportunities for trading or other services
  • Helpdesks and support departments
  • If you forget your username or password, you can reset it
  • You can hold the service provider liable

Cons

  • You miss most of the benefits of Bitcoin
  • Counterparty risk: bankruptcy, hackers, unreliability, fraud, confiscation, technical errors, unforeseen circumstances
  • Not necessarily safer
  • Less financial privacy
  • Sometimes costs are charged, for example at exchanges
  • Know-Your-Customer (KYC) : Sometimes you need to identify yourself through documentation
  • Dutch custodial wallet service providers are not allowed to facilitate transactions to third parties. You cannot therefore make payments via a Dutch service provider

A bitcoin wallet is actually the collection of all unique bitcoin addresses that belong to the seed phrase. You can read more about it here. Are you new to Bitcoin? Then also read our concise starter guide Getting started with Bitcoin.

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