Fundamental to cryptocurrency transactions on a decentralized network, is the concept of self-custody. Users employ noncustodial wallets to control their own assets and to communicate with a blockchain network. Contrary to popular belief, assets are not actually stored in a wallet; rather, the wallet stores the cryptographic keys (public and private) that enable full control of assets. Cryptocurrency should be thought of as data packets, as they represent pieces of information – specifically ownership of a certain value – that is transferred between users. And the blockchain simply records transactions and balances, but does not store or control any assets. Users have total control over said assets, because the cryptographic keys are the only mechanism for access and transmission of the assets.
A user connects their wallet to a blockchain through the internet and can rely on a related application to provide an interface for communicating with the network. The user interface displays the user’s public key or blockchain address for receiving assets, which can be displayed as a long string of characters. When sending assets, the sender specifies the recipient’s blockchain address and the amount to be sent, then uses their private key to provide a digital signature. Under the direction of the user, wallet’s software communicates with the associated blockchain to reflect the updated user’s balance from the ledger as transactions are processed.
Noncustodial wallets generally come in two forms: “hot” and “cold.” The difference between a “hot wallet” and a “cold wallet” is that while a user stores their keys locally on their own device, a “hot wallet” application maintains connectivity to the internet. In contrast, a “cold wallet” (which includes a hardware wallet, i.e., a physical device used for storing keys) keeps keys isolated from internet-connected devices and internet-based attacks. With cold storage, users can connect their device to a computer to sign transactions offline before broadcasting them to the blockchain network through compatible applications, maintaining security while enabling transaction functionality.
In contrast, third-party custodians offer hosted wallets as a service for custodying users’ keys, and therefore assets, on their behalf. This is similar to having an account with a traditional financial intermediary. So, in this circumstance, the user can conduct a transaction the way they would in the traditional financial system: by notifying the custodian so they can conduct a transaction on the user’s behalf. These custodians have total independent control of users’ assets.