A custodial wallet is a crypto wallet that does not give the user the right to self-custody i.e., the exchange or the wallet provider controls the private keys.
These are basically exchange wallets that you get with crypto exchange accounts like Binance or OKX. However, non-exchange custodial wallets, like Satoshi Wallet, also exist.
How Custodial Wallets Work?
Custodial wallets also rely on a cryptographic algorithm to generate public and private keys. Public keys can be shared with others to receive crypto while private keys are used to access your crypto on the blockchain.
However, in this case, the exchange retains the private keys but allows you the added benefit of recovering crypto wallets even if you forget the password, which is not present in non-custodial wallets.
Fun Trivia: A cryptocurrency never leaves the blockchain. It is the private keys that you store in your wallet.
Types
Exchange Wallets
These wallets are those that come with an exchange and are embedded inside the exchange account. You can obtain the public keys to these wallets but not the private keys.
Non-Exchange Wallet
There are many non-custodial wallets that operate independently. I have been using one such wallet since 2021, i.e., the Wallet of Satoshi. This wallet offers email-based recovery and is easy to learn.
Advantages
Password Recovery
You can easily recover your password or restore your wallet with just a simple email-based or social recovery option.
This feature is expected to be introduced with non-custodial wallets, too (via account abstraction), but it has not been done yet.
Easy to Use
These wallets are created for beginners and provide better safety when interacting with unknown sites or dapps. Even though they can perform complex tasks, they are easy to use. The wallet of Satoshi is an example of such a wallet.
Free Transfers
Most exchange wallets offer free transfer of crypto to users within their exchange. This reduces the fee cost to zero in the case of large exchanges like Binance and Coinbase where almost every other crypto user has an account.
Further, it costs virtually nothing to convert a crypto into another. In Binance, it costs me around 1 cent to convert any amount of one crypto into any other crypto, and it happens instantly. As a result, I can receive money, say, in any crypto that another user prefers, and instantly convert it into my fav crypto, which in most cases is USDT.
Receive Multi Chain Assets at One Place
In CEX wallets, you can receive multi-chain assets like USDT, ETH, USDC, and SOL, and the wallet automatically combines them into one, i.e., combines USDT from multiple chains into one.
For example, if you have received 2 USDT each from two sources via, say, Polygon and Arbitrum, you will see a combined 4 USDT balance in your wallet.
You can then send the crypto to someone else or convert it into another crypto for virtually zero fee.
Disadvantages
Censorship
Custodial wallet user’s worst nightmare is censorship. Since wallet providers are mostly exchanges and regulated apps on the Apple App Store or Google Play Store, they are prone to get censored by governments or app providers.
In such cases, users might lose access to all their funds with or without notice.
This is why PayPal was criticized after the launch of PYUSD.
In another incident, Indian crypto exchanges were sanctioned from 2018 to 2020, and users received an ultimatum to sell their crypto or lose it forever. I, too, had to sell crypto when the markets rallied the most in these years.
