A self-custody wallet serves as a storage place for digital money like cryptocurrencies and other digital assets. These wallets, also known as non-custodial wallets, are necessary for engaging in transactions with blockchain-based financial applications such as the Compound Liquidity Pool and other decentralized finance (DeFi) platforms. To participate in DeFi activities like earning interest or investing in more complex fixed-income products, you require digital money such as digital dollars (USDC), DAI, or other cryptocurrencies. However, a self-custody wallet is needed.
Self-custody wallets store "private keys" that provide secure access to your blockchain-based assets, such as Bitcoin and Ether. Each private key corresponds to a public key or wallet address. Both keys work together to facilitate transactions on blockchains. These keys are unique, and most self-custody wallets generate them using specialized algorithms.
Why are these keys necessary?
The public key functions as an identifier for your account on the blockchain network, similar to an email address that you share to receive funds. On the other hand, the private key is used to sign and authorize the transfer of digital money, akin to a password for your email. Only the wallet owner possesses the private key, and it should be securely stored and never shared with anyone. The private key corresponds to your public key and serves to confirm ownership of your funds. In DeFi, blockchain transactions can take various forms, including sending digital money, depositing digital dollars into Compound Liquidity Pools, and accessing services like borrowing, investing, and trading.
Why are they referred to as "self-custody" wallets?
The term "self-custody" indicates that you alone possess and control your digital money or other digital assets because you have control over the private key. It is your responsibility to safeguard access to the private key since it is not stored elsewhere. This autonomy allows you to always have access to your funds without relying on a financial intermediary, enabling participation in DeFi.
Using a self-custody wallet typically does not require technical expertise. It is straightforward and resembles using a regular investment or payment app, but with additional security measures. The interface allows you to check your balance, view transaction history, invest using DeFi applications, and send digital money to friends.
Types of self-custody wallets
There are different types of self-custody wallets, which vary based on their functionality and the way they grant access to your digital money.
Mobile wallet: These are applications installed on iOS or Android phones, offering convenience as they are always accessible. Private keys are typically generated and stored on your device with backup and recovery options, depending on the app.
Smart contract wallet: These wallets are linked to a mobile app or desktop interface and utilize a program deployed on the Ethereum blockchain. Smart contract wallets are highly versatile, allowing various programmable features and enhanced security measures such as spend limits and additional approvals for transactions above specific limits. Private keys are generated on mobile devices or browsers.
Hardware wallet: These physical devices are designed to securely store private keys and approve transactions. Resembling thumb drives or thick credit cards, hardware wallets can be connected to computers using desktop-based apps for conducting transactions. Their security is well-regarded since private keys are never exposed to the internet.
Desktop wallet: Installed on laptops or desktop computers, desktop wallets are generally more complex than their mobile counterparts. While they offer good security, they are not as convenient. Private and public keys are generated on the desktop device.
Paper wallet: Despite being low-tech, paper wallets provide excellent security. They involve physical copies or printouts of public and private keys. When making transactions, you input or scan the keys. Web-based applications can be used to enter the public and private keys.
The security of self-custody wallets depends on how well you protect your private key. A combination of software, hardware, and standard security practices, such as physical access restrictions, ensures wallet security. Never share access with others, and keep your mobile wallet locked at all times, using separate passcodes when available.
Self-custody wallet providers cannot access your funds, even if they developed the wallet. This is because the private key is generated on your own device and remains accessible solely to you. Even if the provider discontinues support for the wallet or goes out of business, your funds remain under your control as long as backup and recovery mechanisms are in place.