Crypto Explainer+
Custodial vs. Non-Custodial Crypto Exchanges: What You Need to Know
(DALL-E/CoinDesk)
Following the downfall of FTX, many crypto investors are wondering if a non-custodial option is a safer bet for their coins.
Updated Nov 30, 2022 at 5:58 p.m. UTC
Robert Stevens is a freelance journalist whose work has appeared in The Guardian, the Associated Press, the New York Times and Decrypt.
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When FTX abruptly collapsed, users around the globe found they could no longer withdraw assets from the crypto exchange. Bankruptcy filings revealed FTX had up to $50 billion in liabilities and it's unclear just what assets remain. Because crypto has no equivalent to something like federal deposit insurance from the FDIC to cover these losses, customers must wait for the bankruptcy courts to claw back what remains of their money – if any remains after investors have taken their cut.
FTX's downfall is a symptom of a problem inherent to custodial exchanges. These platforms only let customers trade funds they have parked on the exchange. While customers are trading on custodial exchanges and leave their tokens there, they are exposed to the risk the exchange could go bust. When exchanges become insolvent, one of the first moves tends to be slowing or stopping withdrawals entirely.
See also: Centralized vs Decentralized Exchanges
Unfortunately, this happens all too often in crypto. Exchanges get hacked (Binance and Coinbase, now the leading crypto exchanges by volume, have both been hacked), and founders like Sam Bankman-Fried may turn out to be less invested in their customers than social media makes them appear.
Another scenario that customers of custodial exchanges face is that bad security practices might mean that when a key founder goes missing, the founder takes their private keys and the access to the funds with them. That's what happened when the founder of QuadrigaCX died suddenly, locking users out of their accounts (it later emerged that he had been squandering customer funds and the cold wallets were largely empty).
Self-custody solutions
One alternative is to use a non-custodial exchange, also known as a decentralized exchange, or DEX. Examples include Uniswap, SushiSwap and dYdX. These are decentralized finance (DeFi) protocols that users connect to without forsaking access to their cryptocurrencies. Traders instead spend money directly from non-custodial wallets, like MetaMask or Ledger, and do not add their money to a wallet owned by the exchange.
This, on the surface, sounds like a far neater solution. Funds are in the hands of customers, preventing a founder from charming his or her way into the control of user funds, then investing them in riskier assets.
There are disadvantages, however. One drawback is that decentralized exchanges are, at least for now, often a lot slower because all trades take place on the blockchain. Another issue is trades can be more expensive. Finally, due to the transparency of the blockchain, transactions are less private than on a centralized custodial exchange.
Another thing to consider with a DEX is you can also only trade crypto for other crypto within the Dex, while centralized cryptocurrency exchanges such as Coinbase allow for the conversion of fiat and crypto currencies (for example, the U.S. dollar and bitcoin).
Plus, for all the commotion about "not your keys, not your coins" – the mantra of non-custodial solutions – it is easy to lose the keys or seed phrase to a non-custodial wallet or to accidentally ruin your hardware wallet in the laundry. The responsibility for holding onto your crypto is squarely your own, meaning there's no customer support to help you if you lose control over your coins. On the other hand, for some the responsibility and sole ownership of your crypto keys is an advantage of non-custodial exchange.
By contrast, custodial exchanges, also known as centralized platforms, are very convenient (when they do not steal your money), highly liquid (when solvent) and very popular (when they work). They are also very cheap because trades take place not on the blockchain but on proprietary matching engines. Consequently, people flock to these exchanges in droves, hoping to profit from the advantages while avoiding the pitfalls.
Aware that people prefer not to have their funds stolen by dodgy exchanges, centralized exchanges are moving – slowly – in the direction of safety and transparency.
Several major exchanges, notably Binance and Kraken, have chosen to publish cryptographically verifiable proof of reserves, which shows how much money they have on hand at any time. This allows customers to check whether the exchange is solvent or if the books look dodgy. That said, critics have pointed out the omission of an exchange like Binance's other liabilities – those to whom it owes money, such as customers and lenders – could undermine the transparency initiative.
Other exchanges, including Coinbase, promise 1-to-1 backing. Coinbase claims all customer funds are fully backed at all times and are never invested or lent out without permission. Coinbase can afford to do this by charging fees for withdrawals and trading. But there's still a risk Coinbase customers could be treated as "general unsecured creditors" in the event of a bankruptcy, meaning they'd have to wait for other investors to claim their share.
See Also: What Are Fully Backed Reserves?
In sum, nothing is perfect and danger can come from any directions. Both custodial and non-custodial exchanges can contain security vulnerabilities that can put your money at risk. There's no perfect solution, but some people find a blended strategy of keeping a portion of crypto in non-custodial accounts and another in more liquid centralized exchange diversifies those risks while allowing them to both trade and HODL their coins.
No matter what, make sure to keep all passwords and keys in private, safe places and make sure to research each place where you're considering putting your crypto before you make a deposit.
Read More: How to Get Your Wealth Off an Exchange
This article was originally published on Nov 29, 2022 at 10:36 p.m. UTC
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