Centralized Exchanges are Dead: The Importance of Self-Custody

Centralized Exchanges are Dead: The Importance of Self-Custody

The era of centralized exchanges is over.

With the recent collapse of FTX — a failed cryptocurrency exchange that lost  and halted withdrawals from the platform — trust in crypto exchange firms is at an all-time low. The fall of FTX has revealed many weaknesses within the larger crypto industry that preyed on the main pitch of financial returns, with one of the biggest being the lack of education surrounding centralized exchanges.

A major problem with centralized exchanges - that has led to this distrust and overall bearish attitude toward crypto - is the true custody over digital assets. As Webacy CEO Maika Isogawa points out in a recent article on the FTX crash, this phrase rings more true today than it ever has:

“Not your keys, not your coin.”

Most centralized exchanges, as custodians by nature, fail to provide investors with actual ownership over their cryptocurrency holdings and other digital assets. In turn, these funds are less protected, leading to instances such as the one that FTX now faces — funds being inaccurately recorded and reported, illegally moved, and irresponsibly used for what ultimately amounts to gambling.

Where many of the problems in the crypto and blockchain industry arise is the misconception of the relationship between crypto exchanges and blockchain technology. As such, resolving the current issues surrounding cryptocurrency exchanges has to do with getting back to blockchain’s decentralized roots.

This article strives to contribute to the educational efforts of blockchain experts and enthusiasts regarding the need for self-custody to maintain true ownership over digital assets. Getting started with self-custody can feel intimidating but ultimately offers investors greater control and authority over their assets and how funds are protected and put to use.

Keep reading to learn about the importance of protecting your digital assets with tools like Webacy, as well as tips for how to get started with self-custody.

What is Self-Custody & How Does it Relate to Centralized Exchanges?

Custody refers to who maintains control over your digital money, wallet, and assets. Self-custody is when the person in control is the investor themselves. To practice self-custody, an investor must own a non-custodial wallet with which only they hold the private key that provides access to the wallet. In other words, the fundamental unit of ownership in decentralized assets on blockchain is to have a wallet where your assets are in that you, and only you, own the private keys to.

Centralized exchanges, like FTX, do not enable self-custody. Rather than directly owning digital assets, investors would essentially provide the funds to exchanges, which offered custodial wallets where the assets would be stored. They handle your funds for you to make it seem easier. On the surface, this made crypto trading much more approachable and simple to beginner investors. Yet, at the same time, it slowly sowed chaos into the industry because of the lack of transparency.

The problem is, investors do not have access to the private keys via this method, meaning they do not have actual authority over their assets unless they withdraw the funds entirely, which was a slow process that required the exchange to reverse commingle funds, and to send to your alternative wallet, or ACH or wire funds back to you.

As we have moved into a more bearish market, this business and investment structure has naturally deteriorated, leaving exchanges without the funds needed to back user investments and investors without access to their money or assets.

By gambling tokens and leveraging greed, exchanges leveraged the inefficiencies in the market on the trading value of these tokens and misrepresented crypto overall. Their main game was to leverage deceptive practices from eager investors to take real fiat currency and to gamble on customers’ behalf. Their practices have nothing to do with self-custody or decentralization, but rather a tale as old as time that involves financial engineering, borderline criminal activity in a largely unregulated space, all in the name of making money.

For those who have deep knowledge or long-time experience in the crypto industry, this has only further highlighted the need to move away from centralized exchanges and back to self-custody solutions.

Understanding Self-Custody & How to Get Started with It

Satoshi Nakamoto — the founder of Bitcoin — published a white paper in 2008 on the concept of a peer-to-peer electronic cash system (aka, cryptocurrency).

In Satoshi’s original paper, the central idea that guides the concept is that all crypto should be available and accessible to people without the use of a middleman (such as a centralized exchange, for instance). This forms the basis of self-custody — providing individuals with the right digital tools and keys needed to maintain total authority over their assets without the help of an intermediary - like something as basic as a bank.

Yet, since centralized exchanges have served as the main authority introducing the mainstream public to cryptocurrency, the middleman has wiggled its way back into the picture, simply because people want ease of use and “safety”.

The key to getting the general public away from centralized exchanges and utilizing self-custody is to make it easier to understand how to get started.

Self-custody offers many benefits, including the ability to sign smart contracts that carry out terms and agreements automatically, as well as the freedom to move funds freely without required intervention from a middleman or intermediary authority.

In general, self-custody is achieved through the use of a non-custodial wallet, which simply means that the owner of the wallet is the only person who knows the private key. Let’s break down some of the specifics about the different types of non-custodial wallets:

  • Hot Wallets: Hot wallets are wallets that are connected to and often stored on the internet. For instance, cryptocurrency exchanges often use a custodial version of a hot wallet that is made accessible through a mobile app or online application. However, many non-custodial wallets are hot wallets as well.
  • Cold Wallets: Cold wallets are wallets that are not stored on or connected to the internet. Though most cold wallets involve external hardware where a person’s private keys are stored, some can involve software that exists on a computer but is not internet-enabled (or can be disconnected).
  • Hardware Wallets: A hardware wallet is a specific type of cold wallet that is stored on a flash drive or external hard drive, rather than directly on the computer. This is often considered the safest type of wallet, as it is secured against hacks and other online intrusions.

As for how to access a wallet, it comes down to doing your research and choosing the right products that fit your needs. Savvy investors of digital assets will often use a combination of cold and hot wallets, using the cold wallet for short-term storage (such as for making purchases or trading) and the hot wallet for long-term storage (such as long-term investments or retirement savings). If you’d like to read more, we have an entire guide written out here.

Addressing the Challenges of Self-Custody Methods

Aside from finding and choosing the ideal self-custody wallets, there are additional challenges that come with self-custody. When you invest through a centralized exchange, many of the regulatory considerations — such as tax and income reporting — are handled for you by the exchange.

Comparatively, you must complete these types of activities on your own with a self-custody wallet.

Luckily, there are several tools out there that can help you manage your self-custody wallet and ensure you are meeting the right legal requirements. One such example is TokenTax, a full-service crypto tax accounting firm that helps investors ensure they are reporting their taxes correctly.

As for ensuring security over your self-custody wallet, aside from using a hardware wallet for long-term holdings, you can also utilize multi-signature tools and contracts that require more than one private key to access and transfer assets to and from.

For instance, at Webacy, we offer smart contracts that can help you keep your assets safe, as well as a method to retrieve your assets if you lose access to your key or if the wallet becomes compromised in some way.

Final Thoughts: Embracing the World of Self-Sovereignty

The fall of FTX has signaled a shift in the crypto space — one that we should look at as an opportunity to return to the self-custody roots of blockchain, rather than a setback.

In a recent video from Binance CEO Changpeng Zhao (known widely as “CZ”), CZ remarks on the importance of self-custody and the business opportunities for those that choose to embrace it, stating that:

“The people holding their own assets will be their own bank.” He also calls for ways to make self-custody feel less complex. There are many companies in this space working towards that reality, including Webacy.

Utilizing tools like Webacy allows investors to simplify the self-custody process, making it easier for even beginning investors to protect their assets now and long after they have moved on from this life. To begin protecting your cryptocurrencies and other digital assets with self-custody solutions, get started with Webacy today.

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