How and where is cryptocurrency stored?

The expression "cryptocurrency is stored in a wallet" is not entirely accurate from a technical point of view. Cryptocurrency wallets are not designed for actual storage of digital assets; they merely store the information necessary for using cryptocurrency. Cryptocurrency is only stored in the blockchain as a chain of records of funds movements between wallets, and "wallet services" allow you to transfer cryptocurrency from your address in the blockchain to others.

Wallets enable the owner to interact with the blockchain, perform transactions, and receive transfers to their address, but they do not directly store the tokens themselves.

The original idea behind cryptocurrencies implied only what are known as non-custodial wallets. In other words, a wallet that only the owner has full access to through a seed phrase. However, with the development of this field, large services have emerged that allow simultaneous handling of both regular fiat* currencies (such as dollars, euros, etc.) and cryptocurrency tokens. These services have taken on the function of maintaining accounts in the blockchain, and they provide users with an interface** similar to a banking application. In general, they are called custodial wallets.

Custodial Wallets

If you have a bank card, you can easily understand what a custodial wallet is. Essentially, it is a service that stores your assets on its cryptocurrency wallet and provides a convenient interface for working with tokens, as well as the ability to quickly and easily buy, sell, and exchange various cryptocurrencies. The most prominent and widespread representatives of custodial services are cryptocurrency exchanges.

How centralized exchanges work:

1. Let's say you want to buy bitcoin.
2. To do this, you go to one of the exchanges, register, go through KYC procedures (identity verification), provide banking details, and deposit dollars into their account.
3. Next, you buy bitcoin with the dollars. Afterward, in your personal account, you will see the purchased bitcoins, which can be exchanged for other cryptocurrencies or sold back for dollars or euros if desired.
4. But in reality, no records of ownership of this bitcoin are created in the blockchain; such a record will only appear on the exchange because the exchange acts as a custodian on your behalf. It's like they give you a receipt that you can dispose of a certain amount of cryptocurrency stored in their wallets.

Any operation you perform on a cryptocurrency exchange (buying, selling, exchanging) is not recorded in the blockchain but is only reflected in the exchange's database.

Custodial wallets have their pros and cons

Advantages:

• if you lose or forget your wallet password, there is a possibility to regain access through the service.
• blockchain does not provide a procedure for canceling transactions, but custodial services sometimes allow compensating for erroneous transfers.
• there are no transaction fees within custodial services, or they are minimal, and processing speed is instant.

Disadvantages:

• in reality, you do not possess the cryptocurrency; it is held in custody.
• during technical maintenance, users cannot access their assets.
• hackers can breach the service and steal their reserves - the exchange will not be able to withdraw the purchased tokens; they simply won't have them in their account.
• funds can be permanently lost if the cryptocurrency exchange is closed by a court decision or if its founders turn out to be scammers.

Non-custodial Wallets

As a complete opposite to cryptocurrency exchanges, non-custodial wallets exist, where the owner has full control over their assets when using such a wallet.

There are various types of non-custodial wallets: browser extensions (MetaMask, Coinbase Wallet, Brave Wallet, etc.), online services (MyEtherWallet, blockchain.com, etc.), desktop applications (Bitcoin Core, Jaxx, Electrum, Avax Wallet, etc.), mobile wallets (Trust Wallet, Jaxx, Electrum, Phantom Wallet, etc.), and hardware wallets (Ledger, Trezor, Safepal, Keepkey, etc.).

All non-custodial wallets are interchangeable!

The ability to manage funds is not tied to a specific application but to the seed phrase they store - the primary password for managing funds on the blockchain.

However, it's not all that simple; non-custodial wallets also have their pros and cons.

Advantages:

• only the owner has access to the funds; locking the application does not freeze the tokens themselves.
• ability to conduct transactions at any time, in any amount, and with any counterparty.
• interchangeability (with the seed phrase, you can access funds from any "wallet application").

Disadvantages:

• if you lose the mnemonic phrase (seed phrase), accessing the assets will be impossible.
• network fees for any operation (transactions can be very expensive in some blockchains).
• transactions occur on the blockchain, which involves significant time costs - around 10 minutes for Bitcoin and 6 minutes for Ethereum with a priority fee, or many hours or even days if you skimp on miner "tips."

If you forget the password to an exchange, you will likely be able to regain access to your account through customer support. However, when using a non-custodial wallet, things are a bit riskier.

The main drawback of non-custodial wallets stems from their main advantage. Access to funds is tied to the seed phrase, and without it, no one can access the wallet under any circumstances. Therefore, losing the phrase is equivalent to the disappearance of funds.

By conservative estimates, due to the loss of seed phrases, around $140 billion worth of funds in btcoin alone has been locked in the world, not to mention the thousands of different types of cryptocurrencies.

So which wallet is better to choose, custodial or non-custodial?

In reality, experienced users use both types of wallets depending on their needs and tasks, and they do not neglect the available advantages of custodial wallets or the security of non-custodial wallets.

It is better to store the majority of your funds, which should only be accessible to you, as well as the portion needed for interacting with decentralized finance (DeFi) applications, in non-custodial wallets.

For convenient and cost-effective token exchanges or active trading, it is much more convenient to use custodial services.

But most importantly, remember that regardless of the type of wallet you choose, it is crucial to carefully follow the principles of safe behavior online and employ the most reliable methods and means of protecting information.

*Fiat money is a type of currency that is not backed by any commodity (such as gold or silver) and does not have intrinsic value. Such money only has value because people agree to its worth, meaning they believe that organizations or other individuals will accept the money in exchange for goods or services. Since the US president declared the unconvertibility of the US dollar into gold in 1971, the world has been using national fiat currencies: dollars, euros, pounds, etc.

**Interface refers to a variety of different elements (tables, windows, lists, buttons, switches, etc.) and a set of rules for user interaction with electronic devices (programs).