Usually referring to the storage of keys, in relation to wallets or exchanges, a non-custodial setup is one in which private keys are held by the user directly.
Non-custodial refers to a service in which the funds or assets aren’t custodied or possessed by a platform or third-party, at any point during a transaction or service period. Instead, the whole process (usually economic in nature) occurs through trustless smart contracts — the complex self-executing series of code that power blockchain networks. This is in contrast to custodial services, which take possession of a user’s funds or assets for safekeeping, management, etc. Non-custodial services are considered the hall-mark and prime example of decentralization and non-reliance to intermediaries. Crypto proponents prefer them over custodial services since the latter incurs more risks.
The risks involved with custodial services include but aren’t limited to censorship, confiscation, downtime, insolvency, added waiting period for processing, complexity and counterparty risk. Typical examples of centralized services are exchanges like Binance and Coinbase, lending/borrowing services like BlockFi, stablecoins like Tether and Binance USD, digital asset management services like Grayscale and Paypal, etc.
On the other hand, non-custodial services are trustless, censorship resistant, generally fast, less complex, can’t be confiscated and carry no risk of insolvency and downtime.
Examples of non-custodial services include decentralized exchanges (DEXes) like EtherDelta, Binance Dex, 1inch and Uniswap, lending/borrowing services like Maker and Compound, stablecoins like DAI and Ampleforth, and digital asset management services like yearn.finance and Genesis Vision. Non-custodial wallet solutions like TrustWallet and hardware wallets like Ledger Nano, Trezor and CoolWallet allow users full ownership and control over their crypto assets through their private keys or recovery seeds.
Custodial services currently have an advantage in terms of recovery and security, allowing reputable centralized services to help users better in the event of theft or malicious activity since most of them are insured. Non-custodial services carry a smart contract risk, in which buggy or error-prone code can be exploited for fund theft. Furthermore, if users lose private keys or access to accounts, they often have almost no way to retrieve their funds. As they control access to their users’ funds, custodial services have much better recovery options available via identification methods.
Increasing anti-money laundering (AML) regulations such as the FATF Travel Rule targeting custodial crypto service providers are also driving users to non-custodial solutions, which allow them to retain their anonymity, for the time being at least.