What are custodial wallets? What are non-custodial wallets? What are the common regulations that apply to each type of project? Where is it best to register a wallet, and which countries are most friendly to crypto wallet projects?
Virtual assets wallet: definition
Generally speaking, a virtual assets wallet is a vehicle, the main activity of which is to help its user to store their virtual assets (in certain cases, fiat currency). It should be noted that the right words here are exactly “to help to store”, but not “to store”. This distinction is important because custodial and non-custodial wallets offer various functions, which will be analyzed in further detail below.
Many wallets have a wide range of correlative functions including:
- Storing fiat currency, which occurs in custodial wallets.
- Swapping one virtual asset for another virtual asset or fiat currencies. It’s a common practice on Trustee Wallet and most exchange wallets.
- Providing accessibility to blockchain worlds and NFTs, as is the case of Metamask, which offers a “gateway to blockchain apps”.
- Staking of virtual assets, which can be done in places like Trust Wallet.
What’s the difference between custodial and non-custodial wallets?
The main difference between custodial and non-custodial wallets is the third-party presence. In the case of the non-custodial wallet, third parties do not store the assets or private keys. Such a wallet is just a client (interface) to a decentralized network that helps users generate private and public keys and store them on their devices. Generally, these platforms' providers do not need licenses or authorizations to operate because they do not act as the custodians of their users' assets. Examples of non-custodial wallets include Metamask, Trust Wallet, Coinomi, and Exodus.
A custodial virtual assets wallet operates a little differently. It is responsible for storing the assets and private keys; therefore, the providers of these wallets must comply with certain requirements. The list may include; obtaining relevant licenses, appointing certain officers, incorporating KYC processes, and meeting cybersecurity requirements. Most virtual assets legal frameworks–or regulators, where there is an absence of a distinct virtual assets legal framework in the jurisdiction–provide for quite strict rules for the service providers in the sphere of custody of virtual assets. Custodial wallets would be recognized as Virtual Asset Service Providers in most countries. For example, in the U.S., Web3 entrepreneurs hoping to launch a wallet must obtain a money transmitter license. In the Cayman Islands, they will need a license for virtual assets custody services. In Estonia, they must gain authorization to act as a virtual currency wallet service provider.
Biggest advantages of custodial and non-custodial wallets
The biggest advantage of the non-custodial wallet is an absence of counterparty risk and greater control for the user of a wallet. The user keeps complete control of their assets and keys. This can be both good and bad, as complete control comes as a burden of holding the assets and bearing all the risk of their loss. On the other hand, custodial wallets give a user of a wallet third-party interaction risk, but with this risk comes a degree of simplicity in managing the assets and a wider range of useful functions (e.g., users may find it easier to access fiat currency). Web3 founders of custodial and non-custodial wallets will want to consider what their user base will be most interested in, as well as the founders’ options for registering their Web3 project and setting up their wallets in a legally secure manner.
Custodial vs. non-custodial wallets: different legal requirements
As custodial and non-custodial wallets differ in terms of interaction with third parties, (non-custodial wallets require users to hold their assets and private keys, whereas custodial wallets result in users’ private keys being held by a third party), the legal requirements related to each are substantially different.
Generally, the provision of non-custodial wallet services does not require a special license or authorization; therefore, Web3 founders should consider general best practices during their legal structuring. For custodial wallets, the better choice will be to find a jurisdiction with special regulations for businesses in virtual assets. Ideally, the jurisdiction should have relatively straightforward regulation and an uncomplicated authorization or licensing process.
It’s also important to stress that there are different KYC/AML requirements for custodial wallets. Such conditions may vary from jurisdiction to jurisdiction, but, as the general rule, in almost all jurisdictions, you will need to:
- draft certain policies and procedures, the list of which depends on the jurisdiction and may include AML/KYC, cyber security, private key storage, risk management, and data protection policies;
- appoint an auditor;
- appoint an anti-money laundering officer or officers (the requirements to which depend on the jurisdiction);
- appoint a qualified manager (the requirements to which depend on the jurisdiction); and
- provide on a regular basis certain submissions to the regulator (audited financial statements, certain reports on KYC/AML, etc.).
Where to register a non-custodial wallet
For Web3 founders considering which type of wallet they may wish to create, it's important to note here that founders of non-custodial wallets will have more options in the context of jurisdictions for registration compared to founders of custodial wallets. Considering that, as a general rule, no license is required in the case of non-custodial wallet establishment, the safest course of action is likely to be following best practices. The following jurisdictions could be used as an example of successful non-custodial wallets:
- The United States of America (Metamask, Trust Wallet, Trustee Wallet, and Exodus)
- The British Virgin Islands (Coinomi)
- Switzerland (BRD)
- Israel (ZenGo)
Where to register a custodial wallet
For a custodial wallet establishment, a Web3 founder should be very aware of the comprehensive–and sometimes extensive–list of requirements about the jurisdiction where they wish to incorporate.
These requirements exist in respect of third-party asset holding, and Web3 founders should also be mindful of the consequences of any breach of such requirements, which could be catastrophic to their Web3 project. Therefore, the best choice of jurisdiction will likely be one with an established special virtual assets legal framework or with a regulator that has a strong understanding of the applicability of local legislation to the custody of virtual assets. The following jurisdictions may be suitable:
- The Cayman Islands, which requires a virtual asset custody services provider license
- Estonia or Lithuania, where authorization to act as the provider of a virtual currency wallet service is required
- The United States, where a money transmitter license in obligatory
- Bermuda, which requires adherence of any custodial wallet services provider to certain regulation
- The United Arab Emirates, where authorization is required, the procedure of which depends on the zone in which the company will be established
- Malta, which requires operation under a VFA 5 License
Find the best jurisdiction for your custodial or non-custodial wallet
Legal Nodes helps Web3 founders work out the best jurisdictions and legal options for Web3 projects including custodial and non-custodial wallets. Request a demo to learn more about how Legal Nodes can help you.
Disclaimer: the information in this guide is provided for informational purposes only. You should not construe such information as legal, tax, investment, trading, financial, or other advice. Mentioning any of the assets in this article is not an endorsement to purchase them.
Taras is a Web3-focused Virtual Legal Officer at Legal Nodes. Since 2018, he has had various projects under his belt, ranging from M&A transactions and ICO management to handling matters concerning Ukrainian laws on virtual assets. Taras loves writing helpful guides on Web3 legal topics and draws his inspiration from doing sports and reading books (his passion is the history of the 20th century).