A crypto wallet is designed for managing and storing web3 assets, such as tokens – fungible, non-fungible, and semi-fungible. Tokens can have various utilities, ranging from currency and identification to event tickets, video game items, works of art, or digital clothing. The two primary categories of web3 wallets are Externally Owned Accounts (EOAs), which are first-generation wallets, and smart contract wallets, which are second-generation wallets. This article will discuss the differences between custodial, non-custodial, MPC, and smart contract wallets.
Custodial Wallets
Custodial wallets are mainly web-based and usually offered by centralized cryptocurrency exchanges. The exchange holds your keys and stores your funds as your custodian. These service providers often require identity verification (also known as KYC or “know your customer”). The interfaces are designed so that users rarely interact with their wallets directly. Their ease of use attracts newcomers who prefer not to manage their private keys.
Custodial wallets provide users with the assurance that they can still access their funds even if they lose or forget their passwords. Most of the time, the password can be reset by the provider. In contrast, the funds of a non-custodial wallet holder can be irrecoverable if the holder loses their private key.
Custodial wallets require significant trust in the institution, which emphasizes the importance of using a reliable exchange and conducting thorough research. If the institution is untrustworthy, incompetent, or compromised by a hacker or rogue employee with privileged access, you risk losing all your funds. Checking whether the custodian is regulated, how they secure your private keys, and if they carry insurance is part of that process.
Examples of custodial wallets include Free Wallet, Binance, BitMex, Bitgo, Blockchain.com, and FTX.
Non-Custodial Wallets
Non-custodial wallet users have complete control over their private keys and funds. Since non-custodial wallets are often more technically complicated than custodial wallets, they are more popular with experienced crypto users. Non-custodial wallets can be browser-based, mobile or desktop applications, or hardware devices.
Users have more freedom with non-custodial wallets, but that freedom comes with more responsibility. Non-custodial wallet providers give users a seed phrase as a backup recovery method. However, anyone with the seed phrase can access the account.
One advantage of non-custodial wallets is their greater compatibility with various web3 applications. Users can enjoy more flexibility and access to multiple decentralized applications (dapps).
Examples of non-custodial wallets include Trust Wallet, Electrum, Exodus, and MetaMask.
MPC Wallets
Multi-party computation (MPC) wallets distribute the signing process of crypto transactions between multiple computers. The process splits a single private key into multiple key shards shared across different devices. MPC wallets require these key shards to be combined to authenticate a transaction.
As a result, an attacker who compromises a single key shard cannot transfer funds from an MPC wallet, which can only be hacked if the threshold number of key shards are compromised simultaneously.
Benefits of MPC wallets include user-friendly custodial to semi-custodial options, the ability to configure additional security features such as transfer limits and 2FA, increased data privacy, and the elimination of a single point of failure from the private key.
Drawbacks include computational overhead, high communication costs, limitations with key rotation, and the lack of gasless transactions and transaction batching.
Examples of MPC wallets are ZenGo, Fireblocks, and Krayon.
Smart Contract Wallets
Smart contract wallets (also known as smart wallets) are an alternative to EOAs and represent the next generation of web3 wallets. Smart wallets store your assets in a smart contract. Programmable smart contracts allow for new features that make them safer, more versatile, and easier to use. For example, smart wallets can have built-in account recovery if you lose a key.
Instead of seed phrases, smart wallets rely on various mechanisms, with “social recovery” being one of the most popular. The social recovery wallet requires a single signing key that can be used to approve transactions. To increase security, you can set up at least three keys. The additional keys are called guardians. If the owner loses their signing key, they can access or contact their guardians and ask them to change the key. Guardians can be controlled by the owner (e.g., via another device) or trusted to a third party like a friend or institution.
Beyond account recovery, smart wallets can make wallet creation and login seamless. Smart wallets like Sequence use multi-key architecture to enable social/email login for users. In other words, Sequence delivers a wallet creation and account login experience that’s familiar and seamless for nearly all Internet users while maintaining the non-custodial principles of web3.
Another significant advantage of smart wallets is the ability to conduct transactions without paying gas fees. Smart wallets allow developers to sponsor their users’ transaction fees. And, for transactions developers don’t want to sponsor, smart wallets let users pay gas fees in any currency they want, not just the native token of a given chain. In addition to saving on gas fees, smart wallets can bundle multiple transactions into one to reduce validation time.
When it comes to compatibility, smart wallets grant users access to a wide variety of web3 applications, similar to non-custodial wallets, while simultaneously empowering users with far more capabilities.
Overall, smart wallets are an excellent way to securely control your funds, unlock the potential of the DeFi economy, and access the next generation of Internet applications and games.
Some examples of smart wallets are Castle, Argent, and Safe (previously Gnosis Safe).
Final Thoughts
Selecting the right wallet for your needs is a crucial decision that depends on various factors, including the features you value most, your experience level, and how you intend to use your wallet. When choosing a wallet, consider the following aspects:
- Security: Prioritize wallets with robust security features, such as multi-signature support, two-factor authentication, and encrypted private keys. Always research the wallet’s reputation and track record to ensure it has not experienced significant security breaches.
- Control: Determine whether you prefer full control over your private keys (non-custodial wallets) or the convenience of having a third party manage your keys (custodial wallets). Remember that with greater control comes greater responsibility for securing your funds.
- Compatibility: Choose a wallet that supports the cryptocurrencies and tokens you intend to hold and is compatible with the web3 applications and decentralized platforms you plan to use.
- User experience: Consider the wallet’s user interface and ease of use, especially if you are new to cryptocurrencies. A wallet with an intuitive interface and helpful customer support can make managing your assets much more straightforward.
- Functionality: Evaluate the wallet’s features and capabilities, such as account recovery options, gas fee management, and transaction batching. Advanced users may prefer wallets with more extensive functionality and customization options.
- Device compatibility: Ensure that the wallet is compatible with your preferred devices, such as desktop, mobile, or hardware. Some wallets may offer cross-platform compatibility, making it easier to manage your assets across multiple devices.
Regardless of the wallet you choose, always follow best practices to ensure the security of your assets. This includes regularly updating your wallet software, using strong and unique passwords, enabling two-factor authentication when available, and never sharing your private keys or seed phrases with anyone. By taking these precautions and staying vigilant, you can better protect your crypto assets and enjoy a more secure and seamless experience in the world of cryptocurrencies.
FAQs
- What is the difference between custodial and non-custodial wallets?
Custodial wallets involve a third-party service, such as an exchange, holding your private keys and managing your funds. Non-custodial wallets give you full control over your private keys and sole responsibility for securing your assets. - What are the main risks associated with using custodial wallets?
Custodial wallets require trust in the institution holding your keys. If the institution is untrustworthy, incompetent, or compromised by a hacker or rogue employee with privileged access, you risk losing your funds. - What are some popular non-custodial wallets?
Trust Wallet, Electrum, Exodus, and MetaMask are some examples of non-custodial wallets. - What is a seed phrase, and why is it important in non-custodial wallets?
A seed phrase is a series of words that serve as a backup recovery method for non-custodial wallets. It is crucial because anyone with the seed phrase can access the wallet, making it essential to keep it safe and secure. - What are MPC wallets, and how do they improve security?
Multi-party computation (MPC) wallets distribute the signing process of crypto transactions between multiple computers, splitting a single private key into multiple key shards. This process increases security because an attacker would need to compromise the threshold number of key shards simultaneously to access the funds. - What are smart contract wallets, and how do they differ from traditional wallets?
Smart contract wallets store your assets in a smart contract, allowing for programmable features that make them safer, more versatile, and easier to use. They offer benefits such as built-in account recovery and the ability to conduct transactions without paying gas fees. - What is social recovery in smart contract wallets?
Social recovery is a mechanism that relies on trusted guardians to help recover your wallet if you lose your signing key. You can assign multiple guardians, who can be other devices you control or third parties such as friends or institutions. - How do smart contract wallets help with gas fees?
Smart contract wallets allow developers to sponsor users’ transaction fees and enable users to pay gas fees in any currency they want, not just the native token of a given chain. They can also bundle multiple transactions to reduce validation time and save on fees. - What are some examples of smart contract wallets?
Castle, Argent, and Safe (previously Gnosis Safe) are some examples of smart contract wallets. - What are some best practices for securing my crypto assets, regardless of the wallet I choose?
Some best practices include updating your wallet software regularly, using strong and unique passwords, enabling two-factor authentication when available, and never sharing your private keys or seed phrases with anyone.