Risks of a Custodial Wallet

The recent bank run that occurred at the FTX, the world’s second-largest exchange, brought the crypto industry to a standstill. FTX used the company’s assets without disclosure, mixing user funds with counter-parties and trading them without explicit consent.

The day before the collapse, FTX only maintained $1 billion in liquid reserves against $9 billion in liabilities, leading to bankruptcy risk.

Many of you must have been concerned about safeguarding your funds after the FTX fallout. The risks of centralized wallets have become evident after FTX seized user funds overnight. FTX is custodial, which means that the users were not able to access their assets as the centralized platform controlled the private keys. And as a result, investors lost billions of dollars.

Such events are not new in the crypto world, and the downfall of over 14 centralized crypto companies in the past decade has wiped out 1.2 million BTC, almost 6% of the current 19.2 million BTC supply out of circulation.

In the past year alone, millions of people have suffered irrecoverable losses to centralized entities like FTX, Celsius, BlockFi, and more. Approximately $1 billion of customer funds have been lost from the FTX exchange.

What are some of the risks of such centralized or custodial wallets?

1. Misuse of Funds: With a custodial wallet, users never have control of their crypto assets and rely entirely on a third-party custodian to store their keys & funds.

2. Single Point of Failure: A custodial wallet is vulnerable to a single point of failure, as the funds are at risk if a rogue CEO or a bad actor decides to flee with the funds or dissolve the company.

3. Lack of transparency and proof of reserves: Centralized exchanges have failed to maintain a certain amount of reserves to honour withdrawal requests from all their customers.

4. Weak security & fund safety measures: If the third party lacks robust security measures, the user risks losing all their funds.

5. Liquidity & Bankruptcy Risks: A centralized crypto company has the power to freeze users’ accounts overnight, misuse their funds, create liquidity crises, and file for bankruptcy, as seen in the recent FTX case.

So, how can you keep your funds secure? Self-custody is the way forward!

Self-Custody is holding your digital assets in a way that only you have access to them. You control the private keys of your wallet and retain complete ownership of your funds. No third party can access your funds, and you are the guardian of your keys. The risk here is that you lose your funds if you lose your keys, and there is no way to recover it.

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Risks of a Custodial Wallet was originally published in The Capital on Medium, where people are continuing the conversation by highlighting and responding to this story.

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