Custodial Wallet

Custodial Wallet Meaning

A custodial wallet is a type of cryptocurrency wallet where a decentralized exchange monitors and manages the crypto assets users deposit. The main purpose of this wallet is to allow a third party, rather than the users themselves, to act as a custodian for the funds.

These wallets operate similarly to bank accounts offered by financial institutions. They are user-friendly and require minimal hassle. Users can deposit and withdraw their crypto tokens as needed. However, unlike non-custodial wallets, users do not have direct oversight of the wallet.

• Custodial wallets function similarly to bank accounts, managed by a third party that oversees users' funds and private keys. Users can deposit crypto assets and tokens into these wallets, facilitating transactions and purchases.
• Individuals need to sign up on a crypto exchange, provide the required details, and undergo KYC and AML verification checks for account security to use a custodial wallet.
• Custodial wallets prioritize account security, utilizing KYC and AML requirements. They offer recovery options in case of emergencies.
• Unlike non-custodial wallets, the ownership of funds rests with the crypto exchange operating the wallet.

Custodial Wallet Explained

A custodial wallet is a digital wallet that lets users store and use their crypto tokens when required. It serves as a guardian for the deposited funds, but with a distinction: a third-party exchange manages the private keys. This management ensures the safety and security of crypto assets, protecting them from malicious attacks. Thus, users need not worry about their assets, as they are kept within a secure exchange.

The mechanism of a crypto custodial wallet resembles that of a bank account. Just as banks provide account numbers and passwords, public and private keys are provided in this case. The account number is akin to the public key, which can be shared. But the password, equivalent to the private key, remains with the user. With crypto wallets, users possess both public and private keys. However, managing the private key can be challenging, as its loss can result in the loss of funds. To address this, custodial wallet providers manage users' private keys.

These wallets are user-friendly, and some custodial wallet providers offer insurance coverage. Certain exchanges also provide backup keys, aside from the public and private keys. These backup keys, stored offline in cold wallets, can serve as disaster recovery measures in case of theft. For instance, when a user wants to withdraw funds, they initiate a transaction using their designated key. Subsequently, the wallet exchange generates a platform key, countersigns, and approves the transaction. The processing time may take a few minutes or until a block fills up.

How To Build?

Building it involves several stages, each with its own set of requirements. Let's explore these steps:

1. Choose a Platform: The first step in creating a custodial wallet is selecting a reputable platform. Users have the option to choose from various crypto exchanges that offer similar services. Some notable custodial wallet providers include BitGo, Binance, Coinbase Custodial Wallet, BitMix, Freewallet, and others. When choosing, prioritize factors such as safety, security, and authenticity.
2. Sign Up for an Account: Once the platform is selected (often referred to as a CEX or crypto exchange), proceed to sign up for an account on their platform. During this step, one must provide your name, email address, date of birth, and other relevant details. After completing the sign-up process, the exchange will guide one to the next steps.
3. Provide Necessary Details: During registration, the exchange will conduct verification checks crucial for setting up the custodial wallet. These checks may include KYC (Know-Your-Customer) details and Anti-Money Laundering (AML) regulations, which vary based on location.
4. Set Up Security: Security is a vital aspect of custodial wallets. Creating a strong password for the registered email address is essential during sign-up. The security check process begins as one provides personal details, such as tax and residential status and payment methods. For advanced security, consider enabling two-factor verification to protect the account from cyber threats.
5. Transfer Funds or Trade: With the details registered and security measures in place, the custodial wallet is ready to use. Utilizing the enabled features, one can transfer funds between wallets or exchanges. Alternatively, they can purchase crypto and NFT (non-fungible token) assets directly from the exchange.

Examples

Let us look at some examples:

Example #1

Suppose Albus is an equity trader operating in the stock market. However, he has recently developed an interest in the digital space. Albus plans to include crypto tokens like Bitcoin, Ethereum, and Litecoin in his portfolio. As a result, he visits the Coinbase platform and signs up for an account. Then, Albus fills in his details and sets a password.

Later, he transferred $5000 to his Coinbase custodial wallet through his bank account. With this amount, he further purchases a few BTC (Bitcoin) and NFT art. But, after some weeks, Albus forgot the password. Yet, he was able to retrieve the password by resetting it again. Likewise, he sends some ETH coins to his friend, James.

Albus forgot the security key in this case, yet the funds were secured. Although he could reset it, the private key was with Coinbase. Thus, the funds were safe with the latter.

Example #2

According to recent crypto news, as of August 2023, the co-founder of crypto fund Blockchain Capital, Bart Stephens, lost $6.3 million of tokens. The hacker (Jane Doe) stole Bitcoin, Ethereum, and other coins from his private wallets via the dark web to cross security checks. He later installed a new SIM and conducted a SIM swap attack. As a result, he also stole $14 million in funds from Stephen's custodial wallet.

Pros And Cons

Here are the pros and cons associated with a custodial wallet:

Pros

1. No Risk of Losing Private Keys: Users don't risk losing their private keys or funds, as the wallet's authority is with the exchange.
2. Recovery and Backup Options: Users can recover and back up during unforeseen events.
3. User-Friendly Interface: These types are beginner-friendly, featuring well-designed interfaces.
4. 24/7 Customer Support: Users can access around-the-clock customer support.
5. Zero Transaction Fees: Transfers made through custodial wallets often involve no transaction fees.

Cons

1. Security Checks and Authentication: Security checks like KYC and authentication are necessary for transactions.
2. Holding Period and Delayed Transactions: A high holding period for purchases can lead to delayed transactions.
3. Limited Control Over Funds: Users don't completely control deposited funds.
4. No Ownership of Private Keys: Since the authority lies with the exchange, users don't truly own their private keys.

Custodial Wallet vs Non-Custodial Wallet

Although these wallets are popular in the crypto market, they have different functions to serve. Let us look at their distinguishable features:

Basis	Custodial Wallet	Non-Custodial Wallet
Meaning	Managed by a third party	The user controls funds and private keys
Accessibility	Restricted to registered accounts	Accessible to anyone
Transaction costs	Lower or zero compared to other wallets	Relatively higher
KYC registration	Mandatory requirement for signing up	No KYC or verification required
Security	Comparatively lower and often compromised	High-security levels
Account recovery	Individuals can recover and back up accounts anytime	Lost private keys result in unretrievable lost funds

Frequently Asked Questions (FAQs)

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