In the rapidly evolving landscape of Web3, non-custodial wallets have emerged as a cornerstone of the ecosystem, embodying the principles of decentralization, user empowerment, and financial autonomy. These wallets are more than just a place to store digital currencies; they are the gateways to a new paradigm of ownership and interaction in a blockchain-underpinned internet.
In the rapidly evolving landscape of Web3, non-custodial wallets have emerged as a cornerstone of the ecosystem, embodying the principles of decentralization, user empowerment, and financial autonomy. These wallets are more than just a place to store digital currencies; they are the gateways to a new paradigm of ownership and interaction in a blockchain-underpinned internet.
In this article we will provide a detailed overview of the mechanisms of non-custodial wallets and how they expand their utility far beyond what the name “wallet” would suggest, highlighting their importance in the broader context of digital autonomy and security. By the end of this article, policymakers will have gained a nuanced understanding of non-custodial wallets’ technological underpinnings, operational mechanisms, and the pivotal role they play in enhancing user sovereignty and enabling innovative approaches to new and existing technologies. Additionally, we will address the challenges and innovations shaping their evolution, providing a comprehensive understanding of their impact on the future of digital finance, commerce, identity, and creator economies.
Tokens are essentially units of ownership on a blockchain, abstracted to represent not just digital assets or currencies but anything that can be digitized, including proof of ownership of real-world assets (often referred to as RWAs). This abstraction simplifies the programming and use of tokens, making them a foundational element of the blockchain's capability to enable true digital ownership and control.
The transformative potential of tokens lies in their ability to shift control from centralized platforms to the users, ensuring real ownership. Unlike digital goods in games or social media identities, which are ultimately controlled by the platforms, tokens offer a way for users to have genuine control over their digital and even physical assets. This shift is a significant departure from the norms of most current digital platforms, where user ownership is more of an illusion, subject to the whims of the platform owners.
In essence, tokens are building blocks for the new era of the internet, the read-write-own era, defined by digital ownership. This concept of ownership extends beyond just the ability to control digital assets; it represents a fundamental shift towards a more decentralized, user-empowered approach to digital interaction, echoing the foundational ideas of the early web but extending them into the realm of tangible ownership rights over digital entities.
Tokens, being the fundamental units of ownership on a blockchain, require a secure storage solution that allows users to manage and interact with them. Non-custodial wallets serve as the essential interface for users to store, access, and control their tokens, making them a crucial component in the management and utilization of tokens within the Web3 ecosystem.
At their core, non-custodial wallets give users complete control over their digital assets. Unlike custodial wallets, where a third party, such as a centralized crypto exchange like Coinbase or Binance, holds the private keys, non-custodial wallets ensure that the user is solely responsible for the safekeeping of their private keys. While storing assets with historically stable entities that undergo routine proof of reserves audits can be relatively safe, it can become dangerous when using less reputable exchanges. A prominent example of this, and a reminder that what appears reputable may not be so, is the FTX disaster in late 2022, where customers lost access to billions of dollars worth of crypto assets. While it is worth noting that as of July 2024, customers are expected to be paid back in full, this is 18 months post-bankruptcy and is not without tradeoffs. One enduring lesson of FTX’s meltdown was this: a crypto holder can ultimately really only trust themselves to shepherd and protect their assets in a fully transparent way.
The risks of custodial asset management are not unique to crypto, as users of traditional financial institutions can become victims of bank runs and lose access to their funds, with the largest bank run in history happening just last year during the SVB crisis. Safety issues aside, users storing their assets in custodial wallets are unable to interact with decentralized applications and the innovative use cases they provide, which we will touch upon later in this piece.
Non-custodial wallets, on the other hand, give users complete control and responsibility over their assets, which can be managed through various means, such as mnemonic phrases, hardware devices, or encrypted files. As the interface for managing tokens, non-custodial wallets play a critical role in the Web3 ecosystem. They are not merely storage solutions for digital currencies, but rather the primary means of interacting with a vast array of decentralized applications (dApps), including DeFi platforms, decentralized exchanges (DEXes), and other Web3 services. Through their wallets, users can:
Securely store, send, and receive various cryptocurrencies and tokens
Interact with DeFi applications to lend, borrow, and earn interest on their digital assets
Engage in decentralized trading on DEXes
Access and manage their digital identities and reputation
Participate in decentralized governance and decision-making processes
Engage with decentralized communities and social networks
By enabling users to perform all these actions while maintaining complete control over their digital assets, non-custodial wallets serve as the gateway to the diverse and innovative landscape of Web3 applications. They empower users to explore and benefit from the full potential of decentralized technologies, without compromising on security or autonomy.
Non-custodial wallets come in various forms, each with their own unique features and trade-offs. The main categories are software wallets and hardware wallets.
Software wallets include web wallets, desktop wallets, and mobile wallets, offering convenience and accessibility. Popular web wallets, like MetaMask and Coinbase Wallet, allows users to interact with decentralized applications (dApps) directly through their web browser. Desktop wallets like Exodus and Electrum provide a balance between security and ease of use, while mobile wallets such as Trust Wallet and Coinomi enable users to manage their assets on the go.
Hardware wallets, like those offered by Ledger and Trezor, prioritize security by storing private keys offline in physical devices. These wallets offer the highest level of protection against unauthorized access and hacking attempts.
In addition to the form factor, non-custodial wallets can also be categorized based on the technologies they employ. Smart contract (SC) wallets, such as Argent and Gnosis Safe, utilize smart contracts to enable features like multi-signature transactions, spending limits, and recovery mechanisms. On the other hand, multi-party computation (MPC) wallets, like Zengo and Torus, use cryptographic techniques to split and distribute private keys among multiple parties, eliminating single points of failure and enabling social recovery.
Social recovery is a crucial feature that addresses the issue of lost or inaccessible private keys. It's estimated that around 20% of all Bitcoin, or approximately $256 billion worth of BTC, is locked in inaccessible wallets due to lost private keys. Social recovery mechanisms allow users to designate trusted contacts who can help recover access to their wallets in case of lost or forgotten private keys, providing a crucial safety net for users. Many people are familiar with stories of Bitcoin wallets containing millions of dollars worth of BTC but with no known passcode, or an engineer with only two more tries left on his passcode before his wallet is permanently locked. These situations highlight the importance of having a recovery mechanism in place.
Non-custodial wallets offer a wide array of benefits that extend far beyond financial control. These wallets provide users with a level of autonomy and flexibility that traditional financial systems cannot match.
Resilience in the Face of Financial Crises
Non-custodial wallets provide a hedge against traditional financial system failures. During times of economic uncertainty, such as the Cyprus banking crisis in 2013 or the collapse of Silicon Valley Bank (SVB) in 2023, Bitcoin and other cryptocurrency adoption often surges as people seek to protect their wealth from bank failures, bail-ins, and capital controls. By holding their assets in non-custodial wallets, users can ensure that their funds remain accessible even in the face of financial turmoil.
The failure of SVB, a major tech industry bank, sent shockwaves through the financial sector and highlighted the vulnerability of traditional banking systems. As news of the bank's collapse spread, many individuals and businesses scrambled to secure their funds, fearing potential losses or restrictions on access to their money.
In contrast, those who held their cryptocurrency assets like Bitcoin, Ethereum, or stablecoins in non-custodial wallets never faced the risk of losing access to their funds due to the failure of a separate entity, as they maintain full control over their assets.
In times of crisis, non-custodial wallets offer a safe haven, allowing users to maintain complete control over their assets without relying on potentially unstable financial institutions. This also reduces the burden on stopgap insurance mechanisms like FDIC insurance, increasing the overall resilience of the US financial system. This resilience is a significant advantage, particularly in an increasingly volatile global economic landscape.
True Ownership and Control of Digital Assets
One of the most significant benefits of non-custodial wallets is the level of ownership and control they provide over digital assets. Users can:
🔒Manage and store cryptocurrencies securely
Example: Alice uses her non-custodial wallet to securely store her Bitcoin, Ethereum, and other cryptocurrencies, knowing that she has full control over her funds and can access them at any time.
🪪Create, build, and control their Web3 identity
Example: Bob uses his non-custodial wallet to create a decentralized identity (DID) that he can use across various Web3 applications. He can build his reputation and control his personal data, without relying on centralized intermediaries. (learn more about decentralized identity in our previous Blockchain Brief on zero-knowledge proofs)
💻Interact seamlessly across various Web3 applications and services
Example: Imagine being able to use the "login with your Google" account feature across the entire internet, but unlike your Google account, you own your credentials in your non-custodial wallet, and you can transact and interact with funds and assets held within it. Non-custodial wallets, particularly those that support multiple blockchain networks, enable this kind of seamless interaction, creating a more integrated user experience as users can engage with a wide range of dApps without the need for separate accounts or logins.
🎨Buy, sell, and mint NFTs
Example: Carol uses her non-custodial wallet to purchase a unique digital art piece as an NFT. She can prove her ownership of the NFT and even mint her own NFTs to sell to others. ). For instance, the ownership and provenance of fine art, historically based on pieces of paper that are difficult to keep and track, can be tracked on chain through digital tokens. Listen to one of our 2024 podcast episodes for more on tokens and cultural institutions.
🙋Participate in decentralized governance through voting on proposals and petitions
Example: David holds governance tokens in his non-custodial wallet, which allows him to vote on proposals related to the development and management of a decentralized autonomous organization (DAO). He can actively participate in shaping the future of the projects he believes in.
This level of control enables new forms of digital ownership and participation in various ecosystems, from gaming and loyalty programs to digital art and proof of attendance protocols (POAPs).
Empowering Creators and Reducing Intermediary Fees
Non-custodial wallets also provide significant benefits for creators. By enabling direct interaction with audiences and reducing the high fees imposed by intermediaries, these wallets allow creators to:
🫶Build direct relationships with their fans
Example: Emma, a musician, uses her non-custodial wallet to create a loyalty program for her fans. She can offer exclusive content, merchandise, and experiences to her fans, without relying on a centralized platform that may take a significant cut of her revenue.
💸Receive payments without intermediaries taking a significant cut
Example: Frank, a freelance writer, accepts payments for his work directly to his non-custodial wallet. He can receive funds from clients worldwide, without paying high fees to payment processors or worrying about chargebacks.
💰Program NFT royalties into smart contracts, ensuring fair compensation for their work
Example: Grace, a digital artist, mints her artwork as NFTs and programs royalties into the smart contract. Each time her NFT is sold on the secondary market, she automatically receives a percentage of the sale price, ensuring ongoing compensation for her creative work.
Enhancing Financial Flexibility and Opportunities
In the realm of decentralized finance (DeFi), non-custodial wallets allow users to participate in a wide range of financial activities, such as:
🤝Lending and borrowing
Example: Hannah uses her non-custodial wallet to deposit her cryptocurrency into a DeFi lending protocol. She can earn interest on her holdings, while also providing liquidity for others to borrow.
💵Earning interest on cryptocurrency holdings
Example: Isaac deposits his stablecoins into a DeFi yield farming protocol using his non-custodial wallet. He can earn attractive interest rates on his holdings, often significantly higher than those offered by traditional savings accounts.
🏦Using their on-chain transaction history as a new form of creditworthiness
Example: Julia has a strong history of on-chain transactions and interactions with DeFi protocols, all recorded on the blockchain. She can use this transaction history as a form of creditworthiness when applying for a loan or participating in other financial opportunities within the DeFi ecosystem.
This opens opportunities for individuals who may be underserved by traditional credit systems, providing them with access to financial services that were previously unavailable.
For example, in many developing countries, a significant portion of the population remains unbanked or underbanked. Non-custodial wallets can provide these individuals with access to financial services, such as savings, lending, and investment opportunities, that were previously out of reach. By leveraging their on-chain transaction history and reputation, they can participate in the global financial system on more equitable terms.
Sub-Saharan Africa has some of the most well-developed cryptocurrency markets, with deep penetration and integration of cryptocurrency into everyday financial activities for many users. Chainalysis’ 2023 Geography of Cryptocurrency Report highlights that retail-sized transfers below $10,000 USD make up 6.4% of the region's transaction volume, more than any other region, and 95% of all transfers in the region are retail-sized. This trend is particularly evident in countries like Nigeria and Kenya, where many young people are turning to cryptocurrency as a way to preserve and build wealth in spite of low economic opportunities. The report also notes that cryptocurrency usage in Sub-Saharan Africa is often driven by everyday necessity, such as preserving savings through economic volatility and enabling cross-border transactions in places with strict capital controls. With limited access to traditional banking but high penetration of mobile phone adoption, crypto based platforms like BoomPay create the opportunity for millions of unbanked people to make digital payments cheaply and securely via their mobile phones.
While non-custodial wallets offer numerous benefits, they also come with inherent risks and responsibilities that users must be aware of.
One of the most significant risks associated with non-custodial wallets is the potential for users to lose their private keys. Unlike traditional financial accounts, where a third party can help recover lost passwords or access, non-custodial wallets place the responsibility of key management solely on the user. If a user loses their private keys, they may permanently lose access to their funds.
To mitigate this risk, users must be diligent in securing their private keys. This can be done through various means, such as:
Storing private keys offline in hardware wallets
Using encrypted files or mnemonic phrases
Implementing social recovery mechanisms, such as those offered by Argent
The decentralized nature of non-custodial wallets also makes them a target for scams and malicious actors. Users must be vigilant in identifying and avoiding:
Phishing attempts that try to trick users into revealing their private keys or seed phrases
Malicious smart contracts that can drain funds from user wallets
Fraudulent projects and ICOs that promise unrealistic returns
Another significant challenge associated with non-custodial wallets is their complexity and learning curve. Users must understand and navigate concepts such as:
Gas fees and network congestion
These are transaction fees required for many interactions that can vary significantly in cost depending on the blockchain network and congestion on said network.
EVM (Ethereum Virtual Machine) compatible networks
EVM compatible networks, which include Ethereum Layer 2 blockchains like Arbitrum and Base (for a detailed breakdown on the difference between Layer 1 and 2 Ethereum, check out our previous Blockchain Brief), and alternative Layer 1 blockchains like Avalanche and BNB chain, can all use the same 0X wallet address and share a number of token standards. However, funds can still be lost if a token isn't bridged onchain correctly or sent using the correct network from a centralized exchange.
EVM network differences and cross-chain compatibility
While EVM compatible networks share similarities in wallet addresses and token standards, non-EVM compatible blockchains like Bitcoin and Solana use entirely different addresses and token standards. This adds complexity when managing assets across multiple blockchain networks.
Bridging assets between different blockchains
Transferring assets between different blockchain networks requires a process called bridging, which can be complex and potentially result in lost funds if not done correctly. Users must be aware of the compatibility between different networks and follow the proper procedures to ensure successful asset transfers.
This complexity can be daunting for those new to the crypto space and may deter some users from adopting non-custodial wallets.
While SVB didn't hold digital assets directly, its collapse still had significant impacts on users holding stablecoins in non-custodial wallets and many entities within crypto industry:
Stablecoin Market Crisis: The failure of SVB caused immediate distress in the stablecoin market, particularly for USDC, a major stablecoin whose issuer, Circle, had $3.3 billion of its reserves with SVB. This led to USDC losing its peg to the dollar temporarily, which is a significant event given the role of stablecoins in providing a supposed 'safe haven' and liquidity within the crypto markets.
Reduced Banking Options: With the collapse of SVB and other crypto-friendly banks like Silvergate and Signature Bank, the crypto industry lost key banking partners. This has likely reduced the available banking options for crypto businesses, potentially leading to lower liquidity and transaction activity in the crypto markets.
Contagion and Liquidity Concerns: The collapse triggered fears of contagion within the financial sector, which could have broader economic implications. For the crypto industry, this meant a heightened risk of liquidity issues, as the banks that failed were crucial for the on and off-ramping of fiat to crypto transactions.
While non-custodial wallets and the ecosystems they interact with can work in tandem with existing financial system and even bolster the overall strength and resiliency the overall industry, in the current regulatory environment, systemic risk to traditional banks can impact the crypto industry even when users are holding funds in non-custodial wallets.
The non-custodial wallet landscape is constantly evolving, with new innovations and developments emerging to address the challenges and enhance the user experience.
One promising innovation is the development of social recovery mechanisms. These systems allow users to designate trusted contacts who can help recover access to their wallet if their private keys are lost. Updates to Ethereum like ERC-4337 and wallets Argent are pioneering this approach, providing an additional layer of security and recoverability without compromising the principles of self-custody.
Account abstraction is another area of innovation that aims to simplify user interactions with blockchain networks. By simplifying complex transaction details and hiding them from the user, account abstraction can make non-custodial wallets more user-friendly and accessible to a wider audience. Most smart contract interactions require some amount of gas fee (transaction fee) to be paid by the account conducting the transaction. Even on highly performant chains like Solana where transactions cost fractions of a cent, this can still be a barrier to entry for consumer accounts at scale. Account abstraction will allow for these fees to be abstracted away and absorbed by the Dapp rather than falling to the consumer. This development has the potential to significantly lower the barriers to entry for those new to the crypto space.
Embedded wallets, like those offered by Privy and Dfns, enable non-custodial functionality to be directly integrated into applications and platforms, creating a seamless user experience. This integration can help bridge the gap between traditional web interfaces and decentralized applications, making it easier for users to interact with Web3 services.
MetaMask, one of the most widely used non-custodial wallets, has recently introduced a new feature called MetaMask Snaps. Snaps are like browser extensions for your wallet that run in an isolated environment and extend the functionality of the MetaMask wallet. They allow developers to add new capabilities, such as:
Interacting with non-EVM networks
Providing transaction insights and analytics
Introduce active and retroactive security checks to help users avoid scams, phishing attacks, and hacks
Enabling push notifications and wallet-to-wallet messaging
This modular approach to wallet extensibility opens up new possibilities for customization and innovation within the MetaMask ecosystem. As more developers begin to experiment with Snaps, we can expect to see a wide range of new features and use cases emerge, further enhancing the capabilities of non-custodial wallets.
As non-custodial wallets continue to gain traction, scalability and user experience will become increasingly important. This will drive innovations like improvements to gas fee estimation and management, or advancements in cross-chain communication and interoperability. Some innovations that address these needs are already here – updates to Ethereum like the recently implemented and planned launch of full danksharding will continue to reduce transaction costs and increase transaction speed of Layer 2 scaling solutions like rollups and sidechains.
As non-custodial wallets gain traction, they face a complex regulatory landscape. Policymakers are grappling with how to apply existing financial regulations to decentralized technologies. Proposed rules around self-hosted wallets, such as the Financial Action Task Force's (FATF) "travel rule" requiring Virtual Asset Service Providers (VASPs) to share the identities of the originators and beneficiaries for transactions exceeding a certain threshold, could have significant implications for non-custodial wallet providers and users.
Some considerations policymakers should have in mind to create a policy landscape that provides flexibility for financial tools like non-custodial wallets include:
Balancing Innovation and Consumer Protection: To foster innovation while protecting consumers, policymakers should strive to create a regulatory framework that balances these objectives. Over-regulation could stifle the development of non-custodial wallet technology and limit its potential benefits.
Importance of Consumer Education and Consumer Choice: Non-custodial wallets represent a paradigm shift in digital ownership and control. As such, consumer education is crucial to ensure users understand the risks and responsibilities associated with self-custody. At the same time, regulations should preserve consumer choice, allowing individuals to decide whether they prefer the convenience of custodial wallets or the autonomy of non-custodial alternatives.
Non-Custodial Wallets Enable Digital Ownership and Interaction: Non-custodial wallets are not just a means of storing funds but the way users can interact with applications, and truly own their digital assets and identities. Regulations should recognize the broader implications of non-custodial wallets for digital ownership, identity, and participation in the emerging decentralized economy.
Resilience During Economic Crises: Non-custodial wallets can provide resilience during economic crises, ensuring that users have access to their funds while also reducing the burden on traditional safety nets like FDIC insurance.
Engagement with Industry Stakeholders: Engagement with industry stakeholders is crucial for policymakers to better understand the unique characteristics and risks associated with non-custodial wallets. This collaborative approach can help inform balanced regulations that protect consumers while fostering innovation.
Addressing Cross-Border Challenges: The decentralized nature of non-custodial wallets presents challenges for cross-border transactions and regulatory oversight. Policymakers should explore ways to harmonize regulations and facilitate international cooperation to ensure a consistent and effective regulatory framework.
Mitigating Systemic Risk Through Clear Stablecoin Regulations: While some stablecoin issuers like Circle (the issuer of the USDC stablecoin) have maintained a consistent record and availability of their proof of reserves, the regulatory ambiguity surrounding cryptocurrency in the US has limited the number of US banks that are willing to work with crypto companies. This creates larger opportunity for single points of failure where the crypto ecosystems can be negatively impacted by the existing financial systems. Clear regulatory guidelines, particularly in regards to stablecoins, would allow for an increased number of banks who are comfortable working with crypto companies. This would provide greater opportunity for non-custodial wallets and the broader crypto ecosystem to serve as a complementary component to the existing financial system, increasing overall stability and reducing the risk of cascading failures and systemic risk.
By addressing these considerations, policymakers can create a regulatory environment that supports the growth and adoption of non-custodial wallets while mitigating risks and protecting consumer interests. A balanced approach that fosters innovation, empowers consumers, and recognizes the broader implications of this technology will be crucial in shaping the future of digital ownership and interaction.
Non-custodial wallets are a foundational component of the Web3 ecosystem, embodying the principles of decentralization, user empowerment, and financial autonomy. They enable new forms of digital ownership, financial flexibility, and direct participation in the emerging decentralized economy.
As the Web3 space continues to evolve, non-custodial wallets will play a pivotal role in empowering users, securing digital assets, and driving innovation. By putting users in control of their funds and data, non-custodial wallets have the potential to reshape the digital economy and create a more inclusive and resilient financial system.
The road ahead is not without challenges, but the benefits of user empowerment, security, and innovation that non-custodial wallets bring to the digital economy are undeniable. As more people embrace the ethos of self-custody and decentralization, non-custodial wallets will continue to serve as the gateway to a more open, transparent, and equitable future.
It is important to note that the adoption of non-custodial wallets is not a binary choice. With smart regulation, non-custodial wallets can work both independently and as a complement to the existing financial system. This synergy can increase consumer choice, protect the right to privacy, foster innovation, and strengthen the overall financial system. By creating a regulatory framework that encourages the growth of non-custodial wallets while ensuring consumer protection, policymakers can help unlock the full potential of this transformative technology and pave the way for a more inclusive and resilient financial future.
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