Most people buy their first cryptocurrencies through an exchange or a custodial wallet. But to get a deep dive into the crypto world, it is important to understand the difference between an exchange and a self-custodial wallet.
Exchanges play a very important role in crypto, because they facilitate on-ramp with fiat money. You can transfer dollars or euros and use them to buy bitcoin or Ether with a few clicks, but we must remember that exchanges are centralized solutions.
The true Bitcoin philosophy is decentralization. And to get real decentralization, we need a self-custodial wallet.
Self-custodial wallet vs Exchange (or custodial wallet)
Let’s start from the beginning: cryptocurrencies work with combinations of public and private keys. A public key is like an email – everyone knows it and can send crypto to your address easily. The private key, on the contrary, is used to unlock and use crypto associated with a public key, and therefore it must be kept secret.
Some people think that wallets “store” your crypto, but the truth is that a wallet is really just a software that helps you manage your public and private keys to render your interactions with the blockchain smoother. Therein lies the main difference between a decentralized wallet and a centralized exchange or wallet.
In a decentralized wallet, it is the user who owns and controls the private keys. That is why this type of wallet is known as self-custodial; the user maintains custody of their crypto at all times.
Exchanges, on the other hand, do not give users real control of their assets. When you create an account in a centralized exchange, they will ask you to define an email and a password that you will use to enter the exchange’s platform. However, they do not give you the private keys needed to truly own the crypto.
The confusing thing is that many exchanges give you a public key from which to withdraw or receive crypto. This creates an illusion of decentralization. The private keys are controlled by the exchange, which acts as an intermediary. This is where the term “custodial” comes from; the intermediary keeps the custody of your crypto assets.
Not your keys, not your coins
Self-custodial wallets are those that give users full control of their assets. In self custodial wallets, the private keys are under the possession of the owner of the wallet. But what does it mean to have control over the private keys?
The private key is a code of numbers and letters stored in an encrypted file. Centralized exchanges or custodial wallets maintain large databases with their users’ private keys and must protect them from possible theft or hacker attacks.
The user depends on the exchange not only for the control and safe storage of the keys, but also to be able to use the crypto associated with that key. To send bitcoin or Ether from a centralized wallet, you need the exchange’s permission. If something happens to the company behind the exchange, you might lose your crypto forever.
Self-custodial wallets store the private keys on a device under user control. The user can access their funds at all times, without having to depend on anyone to carry out the transaction. In case there is a problem with the wallet, you can access your funds from another wallet and even from another device. Let’s see how in the next section.
How to recover the private keys?
Using a self-custodial wallet has many benefits, but it also carries greater responsibility. The user is the sole owner of the private keys, so you must ensure that they are not lost. There is no “recover your password” button or anyone to claim in case of loss. However, it is not as complex as it seems.
To facilitate the protection and maintenance of private keys, most decentralized wallets use what is known as a “seed phrase” or “recovery phrase”. It is a phrase of 12 or 24 words randomly selected that allows you to recover your account from any other compatible wallet.
What’s the magic? Well, the 12-word phrase is cryptographically related to your private keys, so it serves as a proof of ownership of the crypto. The main benefit is that it is much easier to write down and remember. It is advisable to write the twelve words on a laminated paper and keep it in a safe place. Some people even recommend making a few copies in case you lose the original.
If you happen to have a problem with your wallet or with the device where it was installed, you can use this phrase to recover your crypto easily. It is like a magic code that allows you to recover your funds anywhere. That’s why you must make sure that you do not lose access to the 12 word phrase.
Types of self-custodial wallets
There are several types of self-custodial wallets, depending on where the private keys are stored.
Hardware Wallets: it is a pen drive-like device where the private keys are stored. It is considered one of the safest options since it is not connected to the internet and therefore less susceptible to hacker attacks.
Web Wallets: they usually work as a browser extension. The user downloads the wallet and then accesses their crypto through a login. The keys are stored on the device that was used to create the wallet.
Mobile Wallets: they are conceptually similar to web-wallets, but work like an application that has to be downloaded to your smartphone. Keys are encrypted and stored on the device. Defiant is one example of a mobile wallet.
Desktop Wallet: these are programs that reside on a computer. Private keys are kept in computer storage.
The power of decentralization
Satoshi Nakamoto decided to title the Bitcoin whitepaper as follows:
“Bitcoin: A Peer-to-Peer Electronic Cash System”
Bitcoin was designed as a fully decentralized payment system and that is what makes it so valuable. Thanks to cryptocurrencies, we can transfer value anywhere in the world without the need for an intermediary to validate our transactions. While exchanges and centralized wallets add a lot of value to the ecosystem, self-custodial wallets are much better suited to the bitcoin philosophy..