By: Jon Avidor, Jason Gershenson and Armando E. Martinez
As cryptocurrency exchange activity continues to grow, it becomes increasingly more important to understand how to protect these assets. Storing cryptocurrency safely is often confusing for first-time and even experienced buyers. Popular digital exchange platforms often make it deceptively easy to assume that they provide retail cryptocurrency traders sufficient asset security.
Such “Custodial Exchanges” were the earliest digital exchange platforms, and necessary to conveniently trade Bitcoin, and the cryptocurrencies that followed. after the advent of Bitcoin. However, the cryptocurrency community at large recognizes the practical advantages of “Non-Custodial Exchanges”.
“If you don’t own your private keys, you don’t own bitcoin”.
The established mantra within cryptocurrency communities – “If you don’t own your private keys, you don’t own bitcoin” – is central to distinguishing the two types of digital exchange platforms. Every platform that facilitates the exchange of cryptocurrency ultimately places the purchased cryptocurrency in an off-blockchain “wallet” that the traders can access and continue to store cryptocurrency in.
A wallet’s public key (akin to bank account number) allows a cryptocurrency trader (and virtually anyone else) to see the funds within a wallet, as well as the history of transactions made with the wallet. Accessing this wallet to withdraw or trade cryptocurrency, however, requires a passcode known a “private key”. The private key is an auto-generated alphanumeric code, and the singular way to access and create transactions with cryptocurrency within a trader’s wallet. Private keys are difficult to remember, and there is often a risk of placing the private key in a location susceptible to theft, or forgetting where the private key was placed all together. Losing the private key for a wallet generally means permanently losing access to the assets within that wallet. Considering that the private key is the tool to control a trader’s cryptocurrency – what does it mean to not own it?
Custodial Exchanges (No Private Key Control)
Custodial digital exchange platforms are the ones that maintain possession of traders’ private keys. These exchanges are considered “custodial”, because at the time a transaction on the exchange is processed, neither the buyer nor seller are in possession of the traded assets – representations of those assets are exchanged off-blockchain, and entirely within the platform’s database. Most major digital exchange platforms, such as Coinbase, Gemini and Binance, are custodial exchanges.
Exchange custodianship of private keys allows crypto traders to access their wallets with a password, and in some cases, additional two-factor authentication via mobile phone. In addition to utilizing log-in processes that resemble most other online services that crypto trading newcomer already uses, custodial exchanges have the highest trade volume, customer support, insurance, and offer the ability to deposit and withdraw fiat currency.
Custodial exchanges also offer speed. Trading takes place off-blockchain, which means transactions can process quickly but at the expense of the transparency that publishing a transaction on-blockchain affords. In other words, when a crypto trader buys bitcoin on a custodial exchange, they technically buying a representation of Bitcoin within the exchange’s database (which the exchange fully controls). Traders only own actual Bitcoin upon withdrawal from the exchange’s wallet to the trader’s wallet. Until then, a trader is at the mercy of the centralized exchange.
Every year, millions of dollars’ worth of crypto are stolen from even the most established centralized exchanges. Aside from direct hacks to a centralized exchange’s customer funds in custody, two-factor authentication — the very method to protect a customer — can be a hacker’s segue for a cybersecurity attack. Other disadvantages that may negate the convenience of a centralized exchange include:
- Inability to Withdraw Cryptocurrency: Website crashes and maintenance cause funds on even the most reliable centralized exchanges to be unavailable at any given time.
- Missing Hard Forks: Hard forks occur when a single blockchain splits, resulting in twice the number of tokens — one for each blockchain Immediately after the 2017 Bitcoin hard fork (which created Bitcoin Cash), and the 2019 Bitcoin Cash hard fork (which created Bitcoin SV), those that could access their private keys had the instant ability to trade the new tokens. However, Coinbase users had to wait weeks for Bitcoin Cash and months for Bitcoin SV, until Coinbase established an internal system supporting the two tokens.
- False Trade Volumes / Manipulation: Since transactions take place on a central ledger and off-blockchain, trade data can be manipulated by the custodial exchange to produce a certain outcome.
For retail traders to ascertain that they are the only ones who have absolute control over their assets, even in the face of a cybersecurity attack, they must trade cryptocurrency using their private-key wallets on non-custodial exchanges.
Non-Custodial Decentralized Exchanges
Non-custodial exchanges can take many forms, including in-person trading, linking an external wallet to a central “bank” to buy or sell cryptocurrency, linking a wallet to an exchange. In all cases, the primary feature is that each cryptocurrency trader can always remain in control of their wallet funds by way of private key ownership.
The analogues to digital custodial exchanges — decentralized exchanges (DEXs)— are built using a blockchain infrastructure, inherently never controls users’ assets, and allows traders to conduct transactions from their own external wallet, or a wallet on the exchange’s blockchain that the user controls. On a DEX, a trader’s Cryptocurrency is deposited into a smart contract which processes then transaction, never interacting with the private key. With no centrally controlled ledger or funds accounts, exposure to hacking and theft is significantly decreased.
However, DEXs still pale in popularity compared to their centralized, custodial counterparts. DEXs often require more technical knowledge to use, exhibit slower performance (issues with scaling the blockchain), and often cannot facilitate trades “cross-chain” (e.g. Bitcoin for Ether). DEXs certainly require more effort and patience from traders, but cryptocurrency communities are committed to solving the accessibility, scaling, and transaction issues in order to increase security, and subsequently, wider cryptocurrency adoption.
When determining which type of exchange to use, prospective or current cryptocurrency traders must decide what is more valuable to them: easier access to one’s digital assets or complete, unequivocal control of these assets. Institutional traders cannot risk any of their respective clients losing access to their assets, so they might choose to operate on a custodial exchange, especially since some custodial exchanges offer insurance against cybersecurity attacks as well as other traditional client services. On the other hand, retail traders might want to overlook the convenience of a custodial exchange to ensure that they are the only ones who have absolute control over their assets by using their private keys within non-custodial DEXs.
It is still too early to determine which type of exchange is “better” for any type of trader. With creative paths to security, access, and complete control, however, both custodial and non-custodial exchanges will entice more activity within the cryptocurrency space in the coming years.