Custodial vs. Non-custodial Crypto Trading and Exchanges

Until the crypto era, we didn’t have many options of kicking out 3rd parties from dealing with our money. The only thing we could do with our funds in a non-custodial fashion (i.e., indirectly) was to keep them under a pillow in cash. In other cases, especially regarding trading and investment, multiple kinds of intermediaries were a must.

Now it’s different. We got a better alternative to a pillow. If we want to be the ultimate boss of our funds, we can turn them into crypto and trade and invest them via decentralized tools with no intermediary involved.

However, such independence can cost us something. As we know, any benefit always has its price.

In this article, we will compare custodial and non-custodial ways of doing things in crypto, primarily focusing on trading. We will also walk through examples of when each might be best for your needs.

Let’s get started.

Difference between custodial and non-custodial

First, let’s give the terms simple definitions.

Roughly, custodial something (trading, account, wallet, etc.) means that there is an entrusted 3rd third party in the process that handles your funds and is in charge of their safekeeping.

On the other hand, non-custodial means that no one but a user stores and controls their funds and takes care of their safety.

In the context of trading, it’s a matter of whether a trader is required to deposit their money with a 3rd party (an exchange or a depositary) or can trade directly from their own wallet.

Custodial trading on traditional markets

When trading on the conventional markets (stocks, commodities, bonds, etc.), retail users usually have to deal with other participants — brokers, depositories, and clearing houses.

The involvement of multiple parties in the process can be explained by the intention of regulators to negate the risks of retail users who may not have sufficient knowledge or expertise to handle things properly in trading.

Another goal here is to provide a kind of checks and balances mechanics, where each professional participant supervises the actions of the other so that none of them has an opportunity to misuse their professional competence against a user’s interests.

Here is how it works in general.

To buy/sell something, a user gives instructions to a broker, a professional market participant who will link them with other traders and ensure the proper execution of a user’s orders.

A user’s funds and assets (precisely, electronic records of them) are kept with another party — a custodian. An exchange functions as a neutral marketplace here by providing its order book.

What is the role of the custodian?

Now let’s look closer at the custodian.

In traditional markets, a custodian is a regulated financial institution (like a bank or a specialized financial entity) that holds customers’ assets for safekeeping in order to minimize the risk of their misappropriation, misuse, theft, and loss.

In general, the fund custodian’s main scope is:

maintaining records of assets ownership and its economic benefits (like dividends) on behalf of clients, and
tracking, settling, and reconciling assets that are acquired and disposed of by clients.

Custodial trading on the crypto market

On the crypto market, custodial trading happens on centralized exchanges (CEXs).

As mentioned above, to start trading, a user is required to deposit their funds with an exchange or its designated partner third party — a custodian.

Who exactly will perform the custodian functions majorly depends on a CEX legal setup, i.e., whether and how it is regulated and what jurisdiction it operates in. Let me explain below.

Non-regulated CEXs

If we take a non-regulated (not licensed) CEX, let’s say operating somewhere in Seychelles or any other jurisdiction not requiring licensing for trading, here is how things happen:

a user deposits money with a CEX’s account, buys/sells assets on their own using CEX’s order book, then withdraws the funds when they want.

As you might have noticed, in this simplified trading process, we see none of the other earlier mentioned 3rd parties — brokers, custodians, and clearing houses.

Therefore, in the case of trading on a non-regulated CEX, all these functions are performed by the exchange itself. A CEX is your broker, custodian, and clearing house all in one. Literally a jack of all trades.

For accuracy, not all non-regulated exchanges are like this. Some try to stick to the best traditional trading practices and voluntarily outsource the custodial functions to the relevant partners.

Regulated CEXs

Now let’s take a look at a more civilized version of CEX — one that is regulated, meaning it has obtained an official license or permission from some official security watchdog to operate.

These types of CEXs usually involve third-party custodians.

On a side note: dealing with a regulated CEX doesn’t automatically mean that your trading will be as safe as traditional non-crypto exchanges. Here is the thing: not all types of CEX licenses are of any legal value. With a license being issued somewhere offshore, a CEX may choose to partner with a questionable custodian that is, in fact, nothing more than yet another crypto startup. There is no guarantee that such a startup will be able to adequately protect and refund users in case things go haywire and there’s a funds dispute.

However, regardless of the mentioned nuance, the point is that in the case of regulated CEXs, the custodian functions are separated from the exchange and rendered by third parties.

Pros and cons of custodial crypto trading

For a better understanding of the pros and cons of custodial crypto trading, let’s assume we got a reputable CEX with the proper license (like OTF or MTF, for example) and a trustworthy custodian.

Pros:

it’s relatively safe (however, something can always happen — this is crypto, after all)
convenient to use
support and recovery in case you forgot or lost your password, and
insurance coverage in case something goes wrong.

Cons:

“Not your keys, not your crypto,” wise crypto saying says. In other words, here we face a good old counterparty risk. Regardless of all the bright things of third-party custody, you are no longer in control over your funds. That’s a third party who is.
It’s adding extra expenses, resulting in extra fees for the customer (you), as there are multiple parties involved in the process.
Your account (and funds!) can be unexpectedly blocked or frozen for multiple reasons: it seems suspicious, an algorithm just randomly did it at its discretion, a regulatory body requires it, etc.
Confidentiality is left alone. Depositing funds with a custodian (whether an exchange or a third party) requires users to pass KYC verification, which implies disclosing personal information (passport, income statement, utility bill, etc.).
Custodian insolvency risk. It can be triggered by market conditions, hacks, or regulatory interventions. When a custodian goes insolvent, its clients can have difficulty accessing their assets.

Most of the issues arising from the custodial trading overlap with the risks of trading on CEXs, which I covered in detail in my previous article. Check it out if you want to dive deeper.

What does non-custodial mean?

As mentioned earlier, the non-custodial method implies that a user remains their funds’ sole owner and custodian.

In practice, the non-custodial effect can be achieved in several ways.

Decentralized wallets

A most common scenario of non-custodial trading is when a user trades on a decentralized exchange (DEX) directly from their decentralized (non-custodial) wallet.

Unlike with CEXs, in this case, users are not required to entrust their funds with an exchange or a 3rd party. Instead, all that is needed is just plugging a wallet into a DEX — that’s it.

A non-custodial wallet provides an interface to interact with a public blockchain directly. It has public and private keys. So trading from such a wallet on a DEX implies that a user authorizes each transaction with their private key and takes care of their assets’ safety on their own

In this scenario, even a regulator can’t access the funds (unless they push you to provide the private key).

Examples of non-custodial wallets

Metamask — the oldest and most adopted non-custodial wallet. It supports all ERC-20 tokens, NFTs, and multiple blockchains, including the Ethereum main blockchain, Binance BNB blockchain, Polygon, Avalanche, and many test networks. Wallet of choice for the Ethereum blockchain.
Trust wallet — a mobile-only non-custodial wallet. Trust wallet supports Ethereum, Binance chain, Cosmos, and Tron network.

Now let’s look at other possible ways to achieve the non-custodial effect.

Decentralized custody

A good example of a decentralized custodian is Qredo. To decentralize private keys, Qredo uses multi-party computation (MPC), which allows splitting the keys into shares. These shares are stored with the MPC nodes, which are distributed on the network. Together, the nodes generate a digital signature to sign transactions without ever producing a private key.

If you want to learn more about the concept of a decentralized custodian, check out this amazing research: Decentralized Asset Custody Scheme with Security against Rational Adversary by Zhaohua Chen and Guang Yang.

Or wait until I get to write an article on this, lol.

Decentralized accounts (dAccs)

The concept of dAccs was first time offered by the Xena Exchange developer team. Essentially, dAccs mean a proprietary clearing protocol, combining elements of centralized trading with segregated decentralized fund storage. For more details about dAccs check Xena’s description page.

Pros and cons of non-custodial crypto trading

First, let’s walk through the bright side of non-custodial trading.

Pros

The big fat pros here is that you have 100% control over your funds. Even a regulatory body can not reach out to your account (for some users, this is especially important, I know).

Cons

Many challenges overlap with the risks of trading on DEXs. I covered them here in more detail.

Here is in short:

Risk of self custody: recovery of assets in case of losing a private key and a seed phrase is impossible. The responsibility of keeping the keys safe rests on the owner as the wallet cannot recover it under any circumstance.
Regulatory limitations: not all types of traders are allowed to engage in non-custodial trading by law or their licenses.
No protection against fraudulent activities. In case of a fraudulent transaction, a DEX cannot reverse the transaction and recover the funds.
No support team to help you out.

Non-custodial vs. Custodial — what to choose?

The choice is defined by answering the following questions:

What kind of trader are you — a retailer or a regulated institution? If the latter, do your license and terms of work permit trading in a non-custodial manner?
What do you believe in and trust more — traditional markets or a decentralized crypto environment?
What’s your risk tolerance, and what price are you ready to pay for lower risks. As we mentioned, the price could be increased fees, giving up on confidentiality, and being ok with account freezes out of the blue.
How diligent are you to manage your private keys and ensure you won’t lose them?

Overall, the answer to what is better lies in the particular perks you are looking for and the sacrifices you are ready to make.

Hybrid trading

As the term suggests, a hybrid way of trading is one that combines elements from both custodial and non-custodial trading or/and allows a user to choose.

For example, an exchange may require depositing funds with its accounts but offer an option of trading through dAccs (we covered them above).

Or it may offer a user to choose whether to trade from the exchange account or their non-custodial wallet.

IMHO, where a trading venue allows a user to pick up options is the best-case scenario. Let’s look at how the hybrid custody is implemented by the Yellow Network.

Alternative ways to deposit funds

Instead of transferring assets to an exchange, a user can enable a MetaMask connection. Then their funds will be secured by a multi-signature smart contract.
Users can also deposit funds to the smart contract with any other hard/software wallet. This resolves major end-user’s concerns about improper funds storage and the safety of their assets.
The security of the end-user’s funds is also ensured by the amount of collateral funds locked with Yellow tokens. As soon as any fraud or malicious activity affecting end-user’s funds is detected on the broker’s side — the dispute system will ensure the return of assets to their rightful owners.

Non-custodial clearing

Yellow Network uses state channel technology for non-custodial crypto clearing. This technology enables high-speed, high-volume transactions at a low cost. The settlement is done using smart contracts.

The article “State Channels Still Beat All Other Layer-2 Scalability Solutions” thoroughly explains how state channels work in the Yellow Network ecosystem. Check it out, you will love it.

Choice of custodian

Also, Yellow Network has both centralized and decentralized custodians as partners: Fireblocks and Qredo. A user will essentially decide which of those will work for them best.

Final thoughts

So what’s the best way to go- a custodial or non-custodial? I will answer as Captain Hindsight here: there is no one size fits all.
Both ways have their pros and cons. Mind your goals, applicable regulatory limitations (if any), risk tolerance, and the level of convenience you seek. Use your best judgment. Experiment, if possible. Enjoy the variety of options that crypto gives us now.

Learn Web3 with Yellow Network. We can’t wait to see you driving this movement!

Check out OpenDAX v4 cryptocurrency exchange software stack on GitHub: https://github.com/openware/opendax

Follow Yellow Twitter: https://twitter.com/Yellow

Join the public Yellow Telegram: https://t.me/yellow_org

Read Yellow Medium blog: https://medium.com/yellow-blog

Read Yellow HackerNoon blog: https://hackernoon.com/u/yellownetwork

Stay tuned as Yellow Network unveils the developer tools, brokerage nodes stack, and community liquidity mining software!