So you have finally taken the plunge and diversified your investment portfolio into crypto, and you're feeling pretty proud about it. You have opened up some exchange accounts, purchased some solid coins, and taken the first step towards your financial independence.
But you may have noticed how sometimes you're unable to send your crypto from an exchange because of "technical difficulties" or "wallet maintenance". Also, these exchanges have started to ask you for more personal information such as your driver's license, utility bills, and a video of you jumping through hoops while holding a note with the date on it.
In recent years, crypto exchanges have become more strict when it comes to identifying their customers. Exchanges like Coinbase, Bittrex and Binance did not have these know-your-customer (KYC) procedures when they were initially founded. Back then, the authorities thought that crypto was just some magical Internet money. But now they are starting to take it much more seriously, and harping on exchanges to gather more information from their customers.
Legislation is being proposed that would require exchanges to acquire even more information from their customers when withdrawing crypto to their private wallets or sending it to merchants. For example, in some countries, whenever you want to withdraw funds from the exchange you have to fill out information such as the full name and residential address of the person you are sending it to.
You are starting to think that perhaps it's time to take control of your crypto and manage your own private keys.
After all, what is the primary difference between cryptocurrency and the fiat currency in your bank account? The fact that it's censorship-resistant, meaning that no one can suspend your crypto wallet or prevent you from sending a transaction. If you keep your crypto on an exchange, however, the old rules of traditional banking still apply, meaning that your account could be frozen or seized, whether on purpose or by accident.
Don't worry, you're not alone. Most people keep their cryptocurrency on centralized exchanges, especially when they are just getting started in crypto. After all, it's the easiest way to store your funds. But realize that managing your own private keys will give you more control over your money, and possibly more peace of mind as well.
Before we go any further, let's define the two different types of crypto wallets you can have:
Non-Custodial Wallet: A wallet in which only you have access to the private keys that control your crypto, meaning that you always have uninterrupted 24/7 access to your funds. Examples of non-custodial wallets include Metamask, Trust Wallet, and Coinomi.
Custodial Wallet: In this case, you hand your private keys over to a trusted third-party such as an exchange like Coinbase, Binance, or Kucoin. In such case, you no longer control the private keys to your crypto, but rather have entrusted them to the exchange.
The Challenges of Managing Your Own Crypto
The truth of the matter is that managing your own crypto with non-custodial wallets can be a bit of a headache.
This is because each cryptocurrency typically requires its own wallet. For example, if you want to own Bitcoin, Ethereum, Solana, EOS, Polkadot, ATOM, and IOTA you would need seven separate wallets, each with their own secret passphrase.
The secret passphrase is a combination 12 or 24 words, from which the private keys of your crypto are derived. These words can be used to recover your crypto in the unfortunate event that you lose your smartphone or your computer breaks down.
You need to write down this passphrase and store it somewhere safe, such as a bank safety deposit box, or some other secret location that only you and perhaps a trusted friend knows about.
Thankfully, there are some wallets that support multiple blockchains. For example, Metamask not only supports Ethereum, but other Ethereum Virtual Machine (EVM) based blockchains as well, such as Fantom and Avalanche.
Wallets like Coinomi and Trust Wallet also support several different cryptocurrencies, like Bitcoin, Ethereum and Solana. Unfortunately it's impossible to find a single wallet that supports every cryptocurrency, so if you want to have a diversified portfolio and control access to your private keys, you will need to manage a variety of wallets.
The key is not to overwhelm yourself, and to take baby steps towards self-custody of your crypto.
To Custody Or Not To Custody, That Is The Question
In order to determine what is the right option for you, let's examine the risks of both Custodial and Non-custodial wallets:
The Risks of Custodial Wallets
- They are similar to traditional bank accounts, meaning that the exchange can suspend your account if they detect "suspicious activity", or they could simply freeze it by accident, leaving you high and dry without access to your funds.
- The exchange could get hacked, and your crypto could be stolen. Reputable exchanges may bail you out with an emergency fund, but lesser known exchanges likely won't help you.
- You have to go through tedious know-your-customer (KYC) procedures, and risk having your identity stolen. On a side note, KYC is antithetical to crypto in the first place, because crypto was supposed to open the financial system to the entire world population, even to those people without ID.
- Their withdrawal functionality can be halted for days, weeks or months, due to technical problems or for maintenance purposes.
The Risks Of Non-Custodial Wallets
- If you lose your device AND your secret passphrase, your crypto would be unrecoverable. There was a famous case of a U.K. man who accidentally threw his computer, along with thousands of Bitcoin, into a landfill, and those Bitcoin are now forever inaccessible.
- A malicious actor discovers your passphrase and uses it to steal your crypto. You should be aware that there are many phishing scams online, in support channels like Discord and Telegram, where scammers pose as support and ask you for secret passphrase. If you hand it over to them, they can use it to quickly transfer your crypto into their own wallets.
So while the most convenient option is to store your crypto in the custodial wallet of an exchange, you also risk losing your funds to hacks and account suspensions. Switching over to self-custody of your private keys can be tedious and invoke anxiety, but in the long run you will have more control over your funds.
Let's say you have a dozen or so different cryptocurrencies and you would like to get them off of the exchanges and under your full control. Of course it will seem like a big deal imagining all the wallets you will have to download and all the passphrases you will have to store securely.
The best thing to do is take things one step at a time.
What is the most valuable asset in your portfolio? Determine which wallet supports that particular asset and download it from the app store. Go through the installation procedure and write down your secret passhprase on a piece of paper and store it in a safe location.
Do you have a trusted friend or family member who could keep a copy of the passphrase for you? Give them a copy of it as well, and make sure they store it somewhere safe.
Finally, withdraw your most valuable crypto asset into the wallet, and verify that you've received the funds. Now you are one step closer to having full control of your crypto. After becoming familiar with the process, you can move on to the second most valuable asset in your portfolio.
The Future of "Crypto Banks" and Self-Custody
Let's take a step back here and look at the bigger picture. Given the sheer complexity of managing multiple wallets and passphrases, the majority of people have little desire to manage their own crypto, at least for now. It may take a major exchange hack or confiscation of assets before people would seriously consider self-custodying their private keys.
So for the time being, we need custody solutions like Coinbase and Binance. However, you should understand the risks of entrusting your crypto to a third-party. You must realize that the crypto doesn't truly belong to you unless you, and only you, are in possession of the private keys.
The most likely scenario, and the way it seems to be playing out now anyway, is that we'll have several major "crypto banks" that will custody customer's private keys. It will be like this until the regulation becomes too burdensome, or major confiscation starts to happen, to the point where managing your own keys becomes the necessary option.