Welcome to Bankless Publishing’s Crypto Basics Series. We’ll be shipping all of our introductory web3 content on Mirror each Monday, enabling users to curate a web3 reference library by minting NFTs on Optimism.
Custody in finance is defined as the right of an entity or person to manage and look after another person or entity’s money, investments, or finances. In modern finance, it’s common for third parties such as banks or centralized exchanges to have custody of our assets. This may seem ordinary on the surface, but it comes with significant risk. We have heard numerous stories about people unable to withdraw their own money from banks because the bank had no liquidity or was in financial distress. In traditional finance (TradFi), the only option for self custody is in the form of cash or illiquid real estate. However, with central banks going haywire over the decades, cash is not the safe haven asset it used to be.
Crypto changes this; it reintroduces the concept of self custody — having total control over your assets without having to involve a third party. In a world where banks run, exchanges go bankrupt, and malicious hacks often happen, it is paramount that your assets are safe and in your possession. The applications that enable crypto self custody are called non-custodial wallets. Some examples include MetaMask, Phantom, Trust Wallet, and Ledger. Beyond giving you peace of mind, self custody ushers in many other benefits:
In order to make crypto more accessible to the general public, several centralized exchanges and applications were born and modeled on the principles of TradFi. Exchanges like Coinbase, Kucoin, and Kraken retain custody of your assets, even though they show up in your account after you purchase them. If any of these exchanges go ‘belly up’ — like Voyager and FTX have done — you might end up losing everything.
In a world where banks run, exchanges go bankrupt, and malicious hacks happen often, it is paramount to ensure that your assets are safe and in your possession.
However, if the same tokens were transferred to a non-custodial wallet like MetaMask, you would sleep soundly knowing that your assets are fully in your care.
You are entirely responsible for your assets; no third party can place restrictions or limits on your transactions. No permissions are required and you are free to buy or sell any number of digital assets. In order to withdraw your own tokens from exchanges, most of them require you to complete a KYC form. With self custody, no such documents are needed and you are free to use your assets as you please.
There are no limits on the amount and number of transactions you can make in a non-custodial wallet. Centralized exchanges often put limits on the amount you can withdraw and on who you can transfer your tokens to. These restrictions are not applicable when your digital assets are stored in a non-custodial wallet.
When a third party is handling your assets, there’s always a risk of mishandling. This could be in the form of hacks or misuse of the assets. We have seen enough examples of this happening in the last few months to know it’s a big problem (FTX, Celsius, Voyager, and banks in Lebanon).
When a third party is handling your assets, there’s always a risk of mishandling.
With self custody, the owner is assured of the security of their assets — the owner of the private key is the only one that has access to the wallet and its funds. While non-custodial wallets have been subject to hacks, this has largely been due to the user’s interaction with decentralized applications that are unsafe and easily exploited.
The concept of self custody introduces us to non-custodial wallets, which are essential for access to decentralized applications. Through these applications we can stake tokens for extra yield, exchange tokens on DEXs, trade NFTs, and play web3 games. While this is an indirect benefit of self custody, it is an important one!
Depending on the use case, there are two types of non-custodial wallets:
These wallets are typically the browser extensions or mobile applications that many users are familiar with. They enable you to store your digital assets and interact with all the various decentralized applications with ease. Hot wallets are simple to use as they are always connected to the web and transactions can be made easily without having to physically connect any device to your phone or laptop.
However, because they are always connected to the web and interact with many applications, they are susceptible to hacks. Storing large amounts of crypto in a hot wallet is risky.
Cold wallets are the most secure form of storing digital assets. Most cold wallets are attached to hardware, usually a USB stick that serves as a form of two-factor authentication. Only the person who has physical possession of the wallet and who knows the pin can access the funds. Since cold wallets are not connected to the web, they are much harder to hack. This makes them one of the safest modes of self custody. Some examples are Ledger, Trezor, and KeepKey.
Moving your assets from centralized exchanges to a non-custodial wallet might seem daunting and scary at first. However, the benefits of doing so far outweigh the initial discomfort. You can’t stay on the cutting edge if you’re not on the frontier!
Crypto is built on the idea of financial freedom and self custody is an important step towards achieving that. We have been at the mercy of custodians for too long and it’s time we take control of what’s rightfully ours.
A version of this article was originally published by Bankless Publishing on December 3, 2022.
theconfusedcoin is a DeFi dabbler, NFT connoisseur, and writer at BanklessDAO.
Trewkat is a writer, editor, and designer at BanklessDAO. She’s interested in learning about crypto and NFTs, with a particular focus on how best to communicate this newfound knowledge to others.
ab_colours is a versatile designer with over seven years of experience. He specializes in doing product design, UX design and brand identity. He has been DAOing for the past eight months and has been able to amass quite a lot of knowledge about the fascinating blockchain space.
BanklessDAO is an education and media engine dedicated to helping individuals achieve financial independence.
This post does not contain financial advice, only educational information. By reading this article, you agree and affirm the above, as well as that you are not being solicited to make a financial decision, and that you in no way are receiving any fiduciary projection, promise, or tacit inference of your ability to achieve financial gains.
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