Using CEXs to store your assets can bring you risks and losses. Learn better ways to keep your crypto.
Self-custody is often overlooked as one of the most significant benefits and possibilities that cryptocurrencies offer. The recent and unfortunate events regarding the FTX mishandling of more than $10B in customer funds have reminded us that no matter the size or reputation of our custodians, relying on someone else to safeguard our assets poses a significant risk that can expose us to unexpected adverse events like theft or fraud.
The FTX fiasco has prompted us to write this article, which intends to serve as a guide for anybody wanting to participate in the crypto revolution while minimizing trust assumptions about traditional companies. Read on to learn how to do everything, from storing to trading and even investing, while keeping full control of your assets. So, first of all…
Self-custody is a method for individuals to store their cryptocurrencies instead of relying on a third-party custodian. This ensures that users control their own funds, providing them greater financial privacy and autonomy.
To use and move your cryptocurrencies around, a secret key is always needed for every address that holds them. This private key is a long and indecipherable password that can be stored in different ways that we will describe later. For now, know that if you know the address in which your funds are and the derived private key that can move them, then you are already practicing self-custody and you have complete custody of your assets. Conversely, whenever you send your crypto assets into any exchange, trading venue, or wallet service where you only know the address of your funds but not the controlling private keys, you are relying upon somebody else's handling and management.
The differences between these two types of keys can be seen in the following image:
Before jumping into the guide on how to keep self-custody, let's talk about the most common form of third-party custody and a history of related shortcomings.
CEXs, or "Centralized Exchanges", are online marketplaces where customers can buy and sell digital assets. They are the most common custodial storage method for cryptocurrencies because they are highly convenient. The best CEXs in the world have great UIs, competitive trading fees, lots of tokens to trade against, and many other valuable services like the ability to deposit and withdraw fiat money from traditional banking institutions. In this link, you can find an updated list of the biggest CEXs, ranked by trading volume.
Nevertheless, many of the biggest and most widely-used CEXs have failed tragically throughout the short history of cryptocurrencies. Let's revisit some of them...
Mt Gox was a Tokyo-based bitcoin exchange launched in 2010. Back in the day, it was the largest bitcoin exchange in the world, handling over 70% of all global bitcoin transactions. However, in 2014, the company announced that it had been hacked, resulting in the loss of 850,000 bitcoins (worth around $450 million at the time).
After these events, the company declared bankruptcy, and an estimated 24,000 investors lost all their money. The impact of its collapse was so significant that the global bitcoin markets crashed by around 65%, taking the digital token from $1,100 to $375 dollars.
QuadrigaCX was a Canadian cryptocurrency exchange founded in 2013. It rapidly became the largest cryptocurrency exchange in Canada, handling more than $200 million in daily transactions.
In 2019, its founder, Gerald Cotten, allegedly died while traveling in India under mysterious circumstances. Purportedly Cotten was the only person with access to the exchange's wallets' private keys, which meant that QuadrigaCX was unable to return their funds to more than 115,000 customers. Netflix exhibits the scandal in the aptly called "Trust No One" documentary, Netflix shows the scandal.
FTX was founded in 2019 by Sam Bankman-Fried and quickly grew from a smaller crypto options trading platform to one of the largest crypto exchanges worldwide, with over $22 billion in daily trading volume and many innovative products such as perpetual futures, leveraged tokens, and indexes. FTX was, at its peak, the third largest crypto exchange worldwide and had many reputable investors and sponsors backing it, including some of the biggest VC firms and several well-known celebrities like Tom Brady and Shaquille O'Neal.
In November 2022, after a series of events led to a solvency crisis, the exchange halted all user withdrawals and declared bankruptcy. Current evidence shows a possible history of funds mismanagement and embezzlement in collaboration with cryptocurrency trading firm Alameda Research. It is unclear, alas, improbable that around one million FTX customers will ever get their funds back.
Although none of these exchanges remain operational today, their sad legacy will live on as an essential lesson of how trusting even the "biggest," the "safest," and the "institutional" custodians can go terribly wrong.
Now that you understand the risks of relying on someone else for custody let's see how you can start…
Admittedly, purchasing cryptocurrencies usually needs to be done within a CEX (another option being acquiring them from another person). But once this step is covered, we can withdraw them into an address we control and navigate into the world of self-custody.
In the same manner that with fiat money, there are four main things that we want to do with our crypto: store it, spend it, trade it and invest it. We'll now learn how to do them all without any third-party custodians.
Remember how the private keys to a cryptocurrency address are a long and complicated password? Well, this password can be kept by its owner like any other information. It can be written on paper, saved in a text file on a computer, stored within a picture, or even learned by heart – which is not recommended!
All these methods have pros and cons, and they can be grouped like so:
Cold wallets store private keys within a device that has never interacted with the internet. These wallets offer the highest level of security since they are not subject to hacking or other malicious attacks. Still, they also provide minor convenience since they require manual action to access funds. Examples of cold wallets include paper wallets and hardware wallets.
Hardware wallets are offline storage devices similar to portable USB drives specially designed to store private keys. Some popular hardware wallets include Ledger, Trezor, and Keepkey.
Warm wallets are downloadable software wallets that can allow users to own their keys but that maintain some form of contact with the internet, like mobile phone apps, wallets on your personal computer or web browser extensions.
These wallets offer more accessibility and convenience than offline storage solutions like paper wallets but are less secure. Some examples of warm wallets include the Muun or the Bitpay apps and the Metamask browser extension.
Depending on your needs, a combination of cold and warm storage is usually a good idea. In the same way you don't carry all your fiat money in your pocket wallet, you can keep your long-term crypto savings in cold storage and then have some spendable crypto in your warm wallets.
Sending peer-to-peer crypto transactions means that you can buy goods or services from someone else and then pay them from your non-custodial wallet. With the appropriate software, you can scan a QR code and then send whatever amount of crypto you choose intuitively and quickly. Any of the apps that we mentioned as examples of warm wallets will be helpful for this kind of transaction.
The next step to using crypto without custodians is to trade them using a decentralized, non-custodial exchange, or DEXs.
For many reasons, users might want to exchange some of their ETH for USDC or buy some BTC with their BNB. DEXs help complete these token trades without holding any funds in a centralized location, meaning their users remain in complete control of their assets.
DEXs like THORChain and Maya Protocol offer their users more privacy and permissionless access to liquidity so that anybody can trade their funds without prior registration or any kind of KYC process.
The final way to use cryptocurrency without centralized custodians is to invest using decentralized finance (DeFi) protocols. DeFi protocols are a set of products and applications that use blockchain technology to enable financial services such as lending and borrowing without needing for any trusted third party or centralized organization.
DeFi protocols have many advantages, like being open-source and accessible to anyone worldwide, regardless of location or financial background. Users need not provide personal information or go through complicated paperwork to sign up for these services.
Getting involved with DeFi can be intimidating at first, so starting with the biggest and most trusted protocols is a good idea. Aave, Curve, and PoolTogether are great places to begin learning and exploring.
In conclusion, using cryptocurrencies without a custodian is already possible for most users and a highly beneficial way to minimize trust assumptions about other people holding something as important as our money for us. Whether you're a beginner or an intermediate user, taking the time to understand self-custody and the proper methods to implement it is essential to exercise crypto in its original and fullest form.
Unfortunately, it is improbable that the FTX misappropriation of crypto funds will be the last event of this type. The risks of fraud and misuse increase hand in hand with the popularity of cryptocurrencies, which is why more and more people need to start using the methods described in this guide to store and access their digital assets. If you are serious about crypto, this is the way to go, and the better one in the long run.