Apart from the nuance of custodianship (custodial vs. non-custodial wallets), the topic of cryptocurrency wallets is, by itself, a confusing subject for many people. Especially newcomers to the world of blockchain.
First, it helps to know what a cryptocurrency wallet is and why you need one.
In a nutshell, they are applications – often in the form of web or mobile apps – meant to serve as a graphical, user-friendly interface for working with blockchains (a.k.a. distributed ledgers). Typically, a user of a given blockchain like Ethereum will pick a compatible wallet (eg: MetaMask) with which to initialize a new account on that chain. Then, once that account is established, they will use that wallet to engage in a variety of account-related tasks. Some wallets are compatible with one or more blockchains while other wallets are compatible with others.
Once an account is established, one common task is to transfer blockchain tokens to another user’s blockchain account. Those tokens can be fungible or non-fungible tokens (described later in this article), the former of which are typically thought of as cryptocurrencies. Transfers of tokens from one blockchain account to another are typically referred to as transactions. Additionally, In the same way that you might go into your bank’s online banking app to see the balance of funds in your bank account, users also use their wallets to view their balances of fungible and non-fungible tokens as well as the history of their transactions.
Now that you know the main purpose of a cryptocurrency wallet, it’s also helpful to know the differences between custodial and non-custodial wallets and for that, it’s helpful to understand the concept of “the custodian.”
Banks as Custodians of Our Fiat currency
If you’ve ever looked at one of those old financial ledgers, you would likely see paper pages that look a lot like what a spreadsheet looks like today; a lot of rows intersected by columns and then hand-filled entries into each of those rows and columns that specify the details of a transaction; the time, date, amount of the transaction, purpose, whether it was a credit or debit, etc. In some cases, the transaction involves an in-flow of revenue into a specific account (credit). In other cases, the transaction might be a payment to an external party (a debit to a different account). And in other cases, it could be the transfer of funds from one internal account to another (much like moving money from one pants pocket to another).
To the extent that each of these flows involves the movement of a fiat currency like the US Dollar or the Euro, there is always someone or some group of people who are technically in control of the physical currency at all times. They essentially hold the keys to the assets. For example, at the moment a sale is made and the funds for that sale are received into an account, the people or groups of people who ultimately have the authority to unlock that account and access its physical funds are responsible for the safety of those funds until the they are transferred to another account that is overseen by someone else or another group of people.
When these sorts of activities are tracked with a traditional ledger, there is typically another party – usually a bank – where the physical tokens (eg: dollar bills) representing those funds are kept. If you received a $10 payment into your bank account, the bank should be able to physically transfer those dollars (from a stash of dollars it keeps on hand in order to satisfy such requests) to you on request (at a teller window or an ATM). The bank has the key to its vault where the physical dollars (the tokens) are kept, it unlocks that vault, removes 10 tokens, and hands them to you. Now that you have taken physical possession of the tokens, you are responsible for their safekeeping. When the bank is holding your dollars for you (or any other assets for that matter), that bank is considered to be the custodian of your assets. If you own a valuable piece of artwork and it is hanging on the wall at a museum, that museum is the custodian of your artwork. When you take possession of these assets – dollars, artwork, or something else – you become the custodian and are considered to be “self-custodying” the assets.
When these sorts of activities are tracked with distributed ledger technology (ie: blockchain), the tokens and transactions are tracked pretty much the same way as they are with traditional ledgers and fiat currencies. There is a ledger that involves assets and those assets are also represented by tokens. But, in the case of a blockchain, the ledger and the tokens are electronic. There is no physical token like there is with a fiat currency (eg: a dollar bill). But there is still a custodian; someone or some party that holds the keys to the assets and who is ultimately responsible for their safekeeping.
Briefly: Fungible vs. Non-Fungible Tokens
Some of those assets may be wholly interchangeable with one another (a.k.a. fungible tokens similar to the fungibility of US Dollars) and other tokens may be non-fungible. An example of a fungible cryptocurrency token is a Bitcoin. All Bitcoins are interchangeable with one another. No Bitcoin is more or less valuable than any other Bitcoin. Non-fungible tokens (NFTs) typically represent something that’s unique and not necessarily interchangeable. If you’ve read articles about the so-called tokenization of real world assets (RWAs), they are typically talking about the assignment of a specific NFT – a blockchain token – to a specific tangible real world item like a piece of real estate, jewelry, or a specific medical record. For example, in place of a traditional title, an NFT could be used as an electronic title for a piece of real estate at a specific street address. The token that represents that title is non-fungible because the real estate itself is a one-of-a-kind asset with a one-of-a-kind value. It might be strikingly similar to other pieces of real estate (for example, a nearly identical abutting property). But it’s not an exact replica and may therefore have a different value than neighboring pieces of real estate.
When such a piece of real estate is represented by an NFT, that NFT typically has a different value than another NFT representing one of the nearly identical neighboring properties. Those NFTs are not guaranteed to be interchangeable and are therefore non-fungible.
However, one huge difference between fiat currencies like the US Dollar and cryptocurrencies like Bitcoin is that you cannot walk up to a teller window at a bank or an ATM and take physical possession of cryptocurrency token. Blockchain tokens like Bitcoin are virtual in nature.
Custodianship of Blockchain Tokens
Even so, in the same way that you have the option of self-custodying some or all of your physical fiat currencies, you have that same option with your virtual fungible and non-fungible blockchain tokens. For example, if you go to the bank that is the custodian of your savings and withdraw US$10 and put those funds into your nice leather wallet, you are now the custodian of that $10. Likewise, if 1 Bitcoin is transferred into a non-custodial cryptocurrency wallet that you control, you are now the custodian of that Bitcoin and/or any other cryptocurrencies or NFTs that are stored in that wallet. The wallet is said to be a non-custodial wallet because there is no central custodian like a bank that looks after it on your behalf. You are self-custodying those cryptocurrencies.
You are also solely responsible for the safekeeping of that wallet. In the same way that you might not get your $10 back if you lose your leather wallet, you might not get your cryptocurrencies back if you lose access to your cryptocurrency wallet. The DeRec Protocol is very much about creating the sort of safety net that’s necessary to make sure that you never permanently lose access to your cryptocurrency wallet.
But, in the same way that you might select a bank to be the custodian of your fiat currency (since the underside of your mattress isn’t the safest place to keep it), you might also look for a similar institutional custodian for your cryptocurrencies and NFTs.
Centralized cryptocurrency exchanges such as Coinbase and Binance are examples of institutional custodians that will look after the safekeeping of your cryptocurrencies in the same way that banks look after the safekeeping of your fiat currencies. To the extent that an institution such as a cryptocurrency exchange basically keeps a wallet on your behalf, that wallet is considered to be a custodial wallet and the institution is considered to be the custodian. As a user and customer of a custodial institution, you have access to your wallet and can do most of the things that you can do as if you “held” the wallet yourself. However, even though the institutional custodian maintains a wallet on your behalf, it is still that custodian that ultimately has control over your assets (and that decides the terms of your access to those assets).
Kind of Like Frequent Flier Miles
One way to help people to understand the concept of a virtual currency and custodianship is to consider the idea of frequent flier miles or hotel points. Many of us are members of airline or hotel programs that award us some number of points for our loyalty. The more miles that we fly with a certain airline, or nights that we spend at a family of hotels, the more points we earn. The more points that we earn, the more we can redeem those points for something else of value.
The more you think about it, the more you’ll realize that your points are a fungible token-like virtual currency and that the travel organization is running a ledger to keep track of the credits and debits to those points. That organization is also maintaining a custodial wallet where those points are tracked on your behalf. You can use that wallet to transact for value (eg: redeem your points for more travel, upgrades, or other goods and services), But that organization is ultimately in charge of whether you have access to that “wallet” and it can even add or subtract points at will.
Of course, one very big difference between loyalty points and cryptocurrencies is that loyalty points can only be used to transact for goods and services that are approved by the travel organization. It’s a closed ecosystem. Even so, the basic constructs are there; the idea of a custodial wallet that’s centrally controlled by a custodian and fungible tokens that have some transactional value.
The Pros and Cons of Custodial Wallets
By far, the biggest advantage of working with custodial wallets is that the institutions who run them can also help users to recover in the event that they lose access to their wallets. This stands in stark contrast to self-custodying with non-custodial wallets where there’s no help desk to contact if you lose access to your wallet. If you were using a non-custodial wallet and you lose the login credentials to that wallet without having previously made a backup record of the wallet’s secret recovery phrase (SRP) or the private keys associated with the blockchain accounts to which that wallet was attached (and there are no backup copies of the wallet), there is a high probability that you will have lost access to all the associated blockchain accounts and any assets (fungible and non-funglible associated with them).
For this reason, millions of users prefer the safety net of a custodial wallet that’s handled by a custodian like Coinbase or Binance. When you rely on a custodial wallet, the custodian holds the private keys to your wallet and then gives you access to that wallet through traditional means of authentication such as a user ID and password. As is the case with traditional custodians like banks, If you lose your user ID and password, the operators of custodial wallets typically offer ways to reset your credentials and restore account access.
But, generally speaking (not specific to Coinbase or Binance), choosing the custodial path comes with its own risks. What if the custodian suffers a catastrophic collapse? Regardless of what caused that collapse (a change in business conditions, incompetence, malfeasance, etc.), you might not be able to recover your assets. After all, the operators of the failed business are the ones in possession of the all-important private keys to your blockchain accounts. They could have unscrupulously abused those privileges.The systems that keep track of that all-important information could have irrecoverably failed. Any number of bad things could have happened that, in the end, keep you from getting access to your assets. In fact, in the cryptocurrency industry, there’s a famous saying: “Not your keys, not your coins.”
When it comes to traditional finance, there are certain protections from such scenarios that are available to investors and consumers. For example, if the bank that custodies your fiat currency goes out-of-business and that bank is covered by the US Government-operated Federal Deposit Insurance Corporation (FDIC), your deposits are insured for up to $250,000. And over the years, the customers of many failed banks have relied on the FDIC to get some or all of their money back. But when it comes to custodians of blockchain related assets such as cryptocurrencies and non-fungible tokens, there is no equivalent of the FDIC. So, when a custodian fails – as the FTX cryptocurrency exchange infamously did in November 2022 – the customers of that custodian might never recover their assets.
Relevance of the DeRec Protocol to Non-Custodial Wallets
A lot of the content that’s been posted to the DeRec Alliance website addresses the non-custodial wallet scenario where the user is in complete control of the private keys to their blockchain accounts and there’s no safety net to protect that user from the loss of those of those private keys (or loss of the credentials to log into their non-custodial wallet or loss of their secret recovery phrase a.k.a. seed phrase). As described across the many articles and FAQs on our website, the Decentralized Recovery Protocol makes it possible to safely backup these and other secrets (see How the DeRec Protocol Securely Prevents the Permanent Loss of Your Most Important Secrets) in a way that they can be easily recovered should you ever lose track of them. The protocol essentially offers a standard safety net that should be built into all wallets as well as other applications that involve secrets that are worth protection (see Understanding the Types of Secrets That Can Be Protected with the DeRec Protocol).
Therefore, for users who have lost track of their passwords to other services and who are terrified of making the same mistake with their cryptocurrency wallet credentials, the DeRec Protocol offers that much needed safety net. But in order for the user to enjoy the benefits of that safety net, wallet developers must add support for the DeRec Protocol into their wares.