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What is a custodial wallet?
A custodial wallet is a third-party platform that someone can use to securely store and manage their cryptocurrency keys. Custodial wallets offer potential benefits for crypto owners, such as convenience and ease of use.
It's important to understand the difference between custodial and non-custodial wallets. Non-custodial wallets are typically set up and managed by a crypto owner. Meanwhile, custodial wallets are normally hosted and controlled by a third-party service, such as an app.
Learn how custodial wallets may work, how they can potentially benefit crypto owners, and possible risks and regulations to consider before getting started.
How do custodial wallets work?
Custodial wallets are crypto wallets that are managed by a third-party platform. Despite the name, custodial wallets don't actually store cryptocurrency. Instead, the third-party provider is entrusted to safely store those keys on behalf of a crypto owner.
When a crypto owner is ready to access their funds and make a transaction, the custodial wallet provider then oversees and authenticates the transaction to make sure it's completed properly and securely.
Potential benefits of using custodial wallets
Custodial wallets may be a beneficial solution for new crypto users and those who don't want to manage their own private keys.
Some of the potential advantages of custodial wallets include:
- Ease of use. Custodial wallets are typically made to be user-friendly and convenient. Because they are managed by third parties, they often don’t require advanced technical knowledge to use.
- Professional management and support. Many custodial wallet platforms may offer customer service, support, and resources to help crypto owners manage their funds.
- Security features. Custodial wallets may have built-in security features like multi-factor authentication and encryption.
- Account recovery. If someone forgets the password to their custodial wallet, they may be able to safely reset it and regain access. On the other hand, if someone forgets the password to their self-managed wallet, they risk losing access to their funds.
- Quick access to sell crypto. In order to sell their crypto, users need to have a balance of crypto on the exchange they want to sell on. Keeping their crypto in the exchange wallet may make this process quicker.
Security measures in custodial wallets
Custodial wallets may implement security protocols to help protect people's information and support safe cryptocurrency transactions.
For example, a safe crypto wallet may use the following:
- Encryption. Private crypto keys may be encrypted to prevent hackers or unauthorized users from accessing the information.
- Multi-factor authentication. Custodial platforms can require two- or three-factor authentication for login. For example, someone may have to use biometric data to access their account or input a code sent to another contact method before being allowed to log in.
- Cold storage solutions. Cold crypto wallets are normally stored offline, where they may be less vulnerable to hacking and theft. Custodial services may offer cold wallet solutions to help people safely store funds until they're ready to be used.
- Multiple signatures required to perform actions. Custodial wallets may require multiple parties to sign off on an action, potentially keeping crypto more secure.
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Potential risks and considerations when using custodial wallets
It's important to understand the potential drawbacks of using custodial wallets and cryptocurrency. Here are some examples:
- Lack of complete control. Custodial wallets are often controlled by third-party providers, not crypto owners.
- Security risks. Many custodial wallet providers have built-in security and protection features. However, if their platform is hacked or compromised, crypto owners could lose access to their keys and funds.
- Limitations of use. Certain custodial wallets may only support specific types of cryptocurrencies or transactions.
- Volatility. Cryptocurrency carries risk due its volatile value. Since crypto isn’t backed by physical assets, its value is based solely on demand and can fluctuate frequently.
Conduct thorough research before selecting a custodial or self-custodial wallet to better understand the potential risks associated with each option.
Regulations and legalities of custodial wallets
Unlike self-custodial wallets, custodial wallet providers may be subject to certain legal requirements and regulations in order to safely operate. U.S. crypto owners should understand these regulations when researching reputable crypto wallet platforms.
For example, custodial wallet providers may need to adhere to certain KYC/AML requirements. This stands for “Know Your Customer" and “Anti-Money Laundering." These regulations are generally used to verify someone’s identity and minimize the possible risks of financial crimes. KYC/AML requirements may vary across jurisdictions.
Regulations and compliance requirements for custodial wallets can also change over time. This may affect the user experience, such as by slowing down transactions or leading to increased fees. Given these legal considerations, consider a trusted and reputable provider when selecting a custodial wallet.
Custodial wallets may potentially be a helpful option for those getting started with cryptocurrency or seeking assistance managing their funds. Many custodial wallets provide user-friendly experiences, customized support, and built-in security features for data protection. But as with any financial platform, there are potential risks and regulations to consider before getting started. For those interested in using custodial wallets, it's important to carefully research available options before choosing a solution.
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