The Spectrum of Crypto Custodianship: Why Non-custodial Wallets Are Attracting Users

When even my septuagenarian grandfather is asking me how much Bitcoin I have, it’s clear that crypto has gone mainstream. And interest is only growing. Not only as a speculative instrument, but also as a means to store value, accumulate wealth, and hedge against inflation.

In other words, people are finally beginning to get it.

As with any burgeoning industry, however, increased interest results in an increased propensity for scams, fraud, and unethical behavior. Complex terminology and unfamiliar user flows mean a steep learning curve for new entrants into the space.

Recognizing opportunity but too risk-averse to dive in head first, newcomers often start with what they know.

Given the popularity of fintech over the past two decades, “what they know” tends to be centralized financial companies with easy onboarding and smooth, user-friendly interfaces.

Exchanges or service providers falling into this category will hold your private keys, so you don’t have to worry about the underlying complexity, but in return, you must trust them to act in your best interest.

But as everything from Mt Gox to FTX has shown, custodians don’t have the best track record.

Then again, going the self-custodial route is also fraught with challenges. Self-custodial may mean you control your private keys and have full command over your crypto, but equally, it means that if you lose access, there’s no backup.

As a result, up to 25% of all Bitcoin is lost forever, and that’s not even accounting for all the other tokens in circulation.

Non-custodial has arisen as a happy medium – neither you nor the service provider fully controls the crypto. Instead, the keys are either segregated (multisig) or sharded (MPC) across multiple entities, and there needs to be consensus to make transactions.

It’s the best of both worlds – a simpler, friendlier user experience paired with top-level security.

What Problem Are Non-Custodial Wallets Solving for Users?

Ultimately, it boils down to the eternal battle between security and convenience. If we place security, represented by self-custodial wallets, on one side, and convenience, represented by custodial wallets, on the other, non-custodial is the spectrum in between.

Different wallets behave in different ways, leading to endless debates within the industry as to what actually constitutes “non-custodial.”

In my definition, it’s where no single entity holds the keys, but the majority of the decision-making is with the user. Depending on the wallet, this is achieved in several ways. Multi-sig, for example, requires more than a single private key for validating a transaction.

These keys are held by predetermined entities, and each must sign a transaction to validate its authenticity.

Multi-party computation (MPC), on the other hand, uses a single private key sharded and distributed across several entities – to sign a transaction, all involved parties must sign with their share of the private key.

While this may sound complicated, the user experience is much more straightforward than that of self-custodial wallets. The complex blockchain operations are executed in the background, while the user enjoys a streamlined flow.

And in the case of MPC, keys can be recovered in emergencies, providing a solution to the limitation of self-custodial wallets wherein users who lose their keys lose their crypto.

But even so, non-custodial wallets are not without their own drawbacks.

Challenges of Non-Custodial Wallets

Let’s return to the question raised in the previous section – what makes a wallet non-custodial as opposed to custodial? If part of the key is with a custodian, is it custodial? Who decides?

My personal take on this – and I’m very much aware that I’ll be at odds with the maximalists for my position – is that it boils down to procedure and intent.

If it’s exceedingly difficult for a wallet provider to take control of a user’s funds or requires multiple laws to be broken, I would argue that it’s non-custodial.

Yes, presumably if the entire company offering wallet technology were to collude amongst themselves and with third-party platforms to take ownership of a customer’s crypto, it could potentially be possible, but then again, keys could also be brute forced – just the chance of success is minuscule.

The same goes for collusion. And if we start down this wormhole, where does it end? Is the cloud or data center in which the keys are stored a custodian? Even with paper wallets, there have been scandals in which the paper wallet generator was found to be stealing keys.

The other side of the argument is whether complicated security measures actually address a user’s needs more than the convenience of abstraction.

On one hand, you’ve got your keys held by a known, regulated custodian – which you can monitor for signs of trouble and withdraw or exchange into fiat – or on the other, you have a non-custodial wallet that you might not fully understand, possibly resulting in the accidental signing of illegitimate transactions or even irrevocably losing access to your keys anyway.

The Elephant in the Room – Regulation

Inevitably, the discussion turns to regulation. Having regulated custodial companies and required stringent know-your-customer (KYC) and anti-money laundering (AML) processes, paired with thorough transaction monitoring, regulatory bodies are now turning to non-custodial and self-custodial wallets.

Recent UK and EU legislation is proposing to implement the same measures for all wallets across the board, meaning wallet providers, whichever level of custodianship they adhere to, will no longer be able to claim exemption from identity verification or the travel rule.

So, What Do Customers Want?

While there will be the inevitable maximalist who wants ultimate security and no regulation – and will be prepared to suffer a lot of hassle for the privilege – the majority of customers, and especially the large untapped majority, want their own degree of compromise between security and convenience and will be looking for the wallet that meets their needs in the most effective way.

It’s always worth remembering that it’s a spectrum – as newcomers to the industry become increasingly familiar with the technology, they may progress from a custodial introduction to full self-custody, or perhaps the non-custodial alternative will prove to be the winning choice.

Bitcoin, the forerunner to all other cryptocurrencies, was initially conceived to offer new possibilities outside the status quo. So isn’t it fitting that the spectrum of wallets that have sprung up to accommodate crypto equally offers a multitude of possibilities?

It’s precisely this freedom of choice that will deliver mainstream adoption.