Custodial Wallets vs. Non-Custodial Solutions - What's Businesses Should Know
Nilos Team
August 30, 2023

In the wake of the recent events surrounding FTX and the ensuing discussions within the crypto community, it's evident that confusion abounds in the ecosystem. Much of this confusion centers around a critical concept: "not your key, not your money." However, there's a prevalent misunderstanding that blurs the lines between centralized exchanges (CEX) and custodial wallets, incorrectly assuming they are one and the same due to the absence of private key ownership. Let's clarify the distinction and explore whether non-custodial solutions are the sole answer to safeguarding your crypto assets.

Centralized Exchanges: The Banking Paradigm

Centralized exchanges like FTX, Celsius, Coinbase, or Binance function akin to traditional banks. They aggregate users' funds into a few wallets owned by the exchange itself, lacking segregation between accounts. Consequently, they have the authority to allocate these funds as they see fit, be it investment, offering loans, or even converting it for their own operational purposes.

As a customer on a CEX, the balance you perceive on your account is essentially virtual, devoid of direct backing by actual assets. This fundamental distinction leads to liquidity crises when numerous customers simultaneously request withdrawals. The exchange often finds itself unable to fulfill these requests due to a shortage of available funds. To mitigate these risks, centralized exchanges should face stringent regulation and maintain substantial reserve requirements, much like traditional banks.

Custodial Wallets: Protecting User Funds

In contrast, custodial wallets represent a technical solution designed to secure users' funds by safeguarding access to a wallet. Providers of custodial wallets, often empowered by Multi-Party Computation (MPC) providers such as Dfns, Fireblocks, or, are not in control of users' funds. Cryptocurrencies are genuinely deposited into real addresses, and providers can only initiate movements upon users' explicit requests. This setup eliminates the possibility of a liquidity crisis since the funds displayed to users mirror the assets genuinely available at any given moment, a fact verifiable through a blockchain explorer.

The "not your key, not your money" narrative can inadvertently hinder the broader adoption of the web3 ecosystem by promoting the idea that all crypto users, including businesses, must be solely responsible for the security of their assets through non-custodial wallets. However, it's important to recognize that your valuables are often safer in a secure vault than hidden under your mattress.

For retail users, there are exceptional non-custodial solutions like ZenGo, employing key encryption and enabling recovery via cloud backups. However, for businesses, the requirements extend beyond an all-or-nothing approach to fund access. Numerous companies are heavily investing in infrastructure security to shield your assets, relieving you of the sole responsibility.

The way forward suggests that the web3 ecosystem should consider stepping away from centralized exchanges until comprehensive regulations and routine audits are established. Retail users can benefit from free, keyless wallet solutions that retain control over their assets while providing straightforward recovery options. In contrast, businesses should explore MPC-backed custodial wallets, offering enhanced security, multi-chain support, and access control.

As we continue building the future of finance and digital assets, it's imperative that we navigate the crypto landscape with a clear understanding of the diverse options available, ensuring the safety and prosperity of our crypto assets.

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