Part of the power and promise of Web 3.0 is the concept of decentralization, the ability to transact without the need for a central authority or an intermediary such as a bank or centralized exchange. While the idea of decentralization is quite easy to understand, the devil is in the details.
Noncustodial Transactions
In a noncustodial, decentralized transaction, users do not deposit their digital assets in a centralized exchange such as Coinbase, FTX, Kraken, or Gemini. Instead, users retain full custody and control over their private keys, which control ownership of all of the digital assets (crypto, NFTs, etc.) in the user’s wallet.
This means that parties doing a decentralized transaction are 100 percent responsible for the outcome. These responsibilities include, but are in no way limited to, security, verification of the target wallets, approval of the smart contract or transaction terms, technical compatibility of the coins or tokens, and every other sociological, philosophical, technological, and legal issue that might arise. Simply said: you’re on your own. If something goes wrong, there’s no one to go see.
Custodial Transactions
Contrast this with a custodial or centralized transaction where you grant a representative the right to control your private keys. In this case, you deposit your digital assets (grant control of your private keys) in an account at a centralized exchange such as Coinbase, FTX, Kraken, or Gemini (and there are many others). And the centralized authority does your transactions for you.
Consumers tend to think of centralized crypto exchanges as “banks,” but this is a mistake. Centralized crypto exchanges are not anywhere near as regulated as banks. Your deposits are not insured, which is a nontrivial point because a centralized exchange has full custody of your digital assets and exchanges get hacked all the time.
Importantly, more and more centralized exchanges comply with KYC (Know Your Customer) regulations, and with AML (Anti-Money Laundering) legislation, as well as Combating the Financing of Terrorism (CFT) procedures. Be sure to research an exchange’s KYC, AML, and CFT compliance statements and its jurisdictional regulatory approval status (the fine print) before doing business with any exchange.
Not Your Keys, Not Your Coins
The crypto OG clarion call, “Not your keys, not your coins,” is rooted in the belief that if someone has the private key(s) to your transactions, the crypto belongs to them, not to you. This is technically true. And while noncustodial trading does shield you from an exchange being hacked, it comes with serious responsibilities.
How Do You Want to Spend Your Day?
There is more to learn than can ever be learned, which is why we live in a world of experts and specialists. If you want to become a crypto security expert, you certainly can. If you want to become a master of smart contract metadata, all the knowledge you seek is open source and readily available for you to consume. If you want to dive deep into tax law, AML, or CFT, nothing is standing in your way. Except… none of these things might be the best use of your time.
If You’re Reading This, Custodial Transactions Are for You
Noncustodial crypto transactions are for experts and specialists. Custodial crypto transactions are for everyone else. I expect some real pushback here, but if any of the information in this article is news to you, then I strongly suggest you do a lot more homework before attempting noncustodial crypto trading. This is not financial advice, it’s just common sense.
Centralization vs. Decentralization
Web 2.0 is often described as centralized. Big tech companies like Google, Facebook, and Amazon hold all of the data they collect and use them to enrich their stakeholders. We, the people who create the data, get free search or photo sharing and news feeds or quick access to stuff we might want to purchase.
Web 3.0 is generally described as decentralized. It is a new internet where big tech has no power, we control our own data, and everyone shares in the value they help create. The important distinction between Web 2.0 and Web 3.0 is the idea that Web 3.0 will not have any central authorities. To some this means operating outside of government regulations. To others, it simply means more freedom to create and earn. There is no agreed-upon definition.
One way to think about custodial trading (as it is today) would be to call it Web 2.1. The big exchanges are semi-centralized. So is OpenSea (the NFT marketplace) and so are many of the crypto, NFT, engage-to-earn, and DAO (decentralized autonomous organizations) projects.
Questions
Some interesting questions about the future of DeFi include: What will Web 2.5 actually look like? Is it a more likely destination than a fully decentralized, unregulated, uncontrollable Web 3.0 world? How do these various DeFi opportunities map to the world’s technological infrastructure? How likely are consumer behaviors to adapt to the concept of “digital” or “programmable” money? I have many more, but I’m interested to know what you think. Join me on Discord and let’s invent the future we want to live in.
Author’s note: This is not a sponsored post. I am the author of this article and it expresses my own opinions. I am not, nor is my company, receiving compensation for it. I am not a financial advisor. Nothing contained herein should be considered financial advice. If you are considering any type of investment you should conduct your own research and, if necessary, seek the advice of a licensed financial advisor.