Custodial and Non-Custodial Exchanges: Choosing the Right Type for Your Strategy

One of the most exciting innovations brought to financial ecosystems by blockchain is the capability to execute digital transactions between two parties without the need for an intermediary.

However, this is only possible within a single blockchain. All transactions in a cryptocurrency network are mutually validated by all users. But cryptocurrencies are numerous and disconnected fr om each other. 

Attempts to connect them through DeFi solutions are being made but the recent $600 million heist from the DeFi platform Poly Networks has shown that there’s still a long way to go. Crypto users still need a trusted party, i.e. a cryptocurrency exchange platform, to swap one coin for another. 

While using a crypto exchange is inevitable for most crypto users, you can choose the level of control over your funds that you’re ready to pass to an exchange.

The majority of the world’s largest exchanges such as Binance or OKEx provide custodial services. You really need to trust such an exchange in order to use it as it takes complete control of your crypto assets. Non-custodial exchanges such as LetsExchange.io only process the amount you send them when converting one coin to another.

Both types have their pros and cons. Their suitability depends on your needs and crypto investment strategies. That’s why it’s important to understand the differences between custodial and non-custodial exchanges.

Custodial exchanges: Pros and cons

Custodial means that the platform is in the custody of your funds. You store your money on the platform’s wallet. You don’t manage the private keys to your assets, a custodial service basically owns the coins in your name. 

If you want to trade on a custodial platform, you need to deposit funds to the wallet hosted there. When you trade, transactions are not registered on the blockchain. They are performed only in the platform’s network. Off-chain transactions fully controlled by the exchange allow custodial platforms to provide advanced trading features such as stop-lim it orders or margin and leverage. 

This also makes swaps faster because you don’t have to wait until a transaction is registered on a blockchain. However, this benefit applies to platforms with sufficient liquidity. If the service lacks liquidity, the transaction might take much longer than expected.

Custodial exchanges might charge lower fees compared to non-custodial platforms. If you use a custodial exchange, you don’t have to pay an additional fee to liquidity providers (the exchange is the liquidity provider itself). However, you are required to pay a fee for withdrawing your funds fr om a custodial wallet.

The security level is lower if you use a custodial service to store your funds. If the exchange is hacked, your coins, as well as the coins of other users, will be stolen. In some cases, it might take ages for the service to reimburse the losses to their users. You might have heard about the hack of Mt. Gox, the leading bitcoin exchange of the early 2010s. They haven’t reimbursed all the losses to their users.

Custodial services will request you to pass complex registration and verification procedures. This nullifies one of the primary advantages of cryptocurrency transactions over fiat money – anonymity and privacy. However, registration allows you to use your bank account for fiat-to-crypto transfers. 

All in all, we can highlight the following benefits of a custodial exchange:

• The speed of transactions if there is enough liquidity

• Advanced trading features

• A possibility to use fiat money

• Lower transaction fees

• Users don’t need to own a wallet, they use a wallet provided by the exchange

Among drawbacks, the most significant are the following:

• Users don’t own their private keys

• Safety and privacy issues

• If there is not sufficient liquidity, a transaction might be delayed

• Withdrawal fees

Non-custodial exchanges: Pros and cons

Non-custodial exchanges are essentially exchange aggregators. They connect to multiple custodial exchanges through API and pull liquidity from them. LetsExchange.io is a classic example of a non-custodial exchange as it doesn’t even require its users to register accounts in order to swap crypto. User accounts are available on the platform but setting them up is optional. They only provide additional features such as exchange statistics and portfolio management tools.

The exchange process on LetsExchange.io works as follows:

• A user selects coins to exchange.

• The platform monitors available orders across all integrated exchanges and instantly offers the user the best rate available in the market.

• The user sends the exchange amount from their wallet to the platform’s wallet.

• The platform executes the swap and sends the exchanged funds to the user’s wallet.

The entire process is automated. All transactions take only the time needed to be registered on a respective blockchain. 

With this system, non-custodial exchanges offer a solution to the privacy and security issues that custodial platforms face. Users get access to the liquidity pools of leading centralized exchanges without the need to register with these exchanges and rely on their off-chain transactions.

You are the only one responsible for the safe storage of your coins. You keep them in your own wallet and set up the security measures that you consider important. The platform doesn’t store your coins and doesn’t manage them. Therefore, if the platform is hacked, your funds still stay intact.

Another significant benefit is the absence of the KYC procedure. As long as the platform serves as an intermediary between you and a liquidity provider, it doesn’t need any personal data to process.

LetsExchange.io also offers limitless swaps and the fixed rate option for users to exclude slippage during the transaction execution.

These benefits come at the expense of advanced trading functionality. Since non-custodial platforms use on-chain transactions, they can’t provide all the trading features offered by Binance, OKEx and others (stop-lim it orders, margin and leverage, derivatives, and so on). Also, fiat-to-crypto transfers can’t be processed without registration and KYC. Non-custodial exchanges serve a single purpose: to exchange one coin for another.

The pros of non-custodial exchanges:

• Anonymity: no registration and KYC required

• Security: your assets are protected by your own wallet

• Wide range of supported coins due to the integration with multiple exchanges

• Aggregated liquidity

• The best exchange rates available in the market

• No withdrawal fees

The cons of non-custodial exchanges:

• No advanced trading features, not convenient for day trading

• No wallet provided, you need to manage your own wallet

• No fiat-to-crypto transfers

• An additional fee on top of the liquidity provider’s commission (often compensated by the profitability of the exchange rate)

Which type is better?

The choice depends on the user's preferences. If you are into day trading, a custodial exchange offers more trading opportunities while a non-custodial exchange just helps you to swap your coins. For trend trading and long-term investing, it’s more important to focus on the security and privacy of transactions along with the absence of limitations. In this case, a non-custodial platform works better.

Disclaimer. This article is paid and provided by a third-party source and should not be viewed as an endorsement by CoinIdol. Readers should do their own research before investing funds in any company. CoinIdol shall not be responsible or liable, directly or indirectly, for any damage or loss caused or alleged to be caused by or in connection with the use of or reliance on any such content, goods or services mentioned in this article.