Bitcoin is all about removing counter-party risk; the fact that you can self-custody with only the need to run software on your device is a revolutionary discovery. When you run a Bitcoin node and generate an offline wallet with a seed phrase, there is no one sitting between you and the monetary network.
You hold the funds, you say what happens to the funds, and you broadcast any transactions directly to the network. Never before has a payment rail been this transparent and provide you with this much control, but it’s all optional.
You can use Bitcoin in this manner, or you can start to involve other parties as long as you’re happy with the trade-offs and the risks involved. In the fiat system, you have no option; you’re always taking counter-party risk, and the banks and the government are all taking on the liabilities on your behalf to keep the network and payment rails functioning.
Normally, it works smoothly, but when it doesn’t, it can be a catastrophic failure. Custody risk is a major problem in traditional financial systems, as it can lead to losses for all parties involved.
Counter-party risk is the risk that one party, usually the customer, takes by entrusting a financial institution with their money with the understanding the institution will perform certain obligations on their behalf.
When you perform a transaction with your bank account or credit card, it’s only by the good graces of the bank infrastructure that it happens, infrastructure that you have no oversight into how it works when it works, and if it will work tomorrow, you unquestioningly trust that they will clear your payment for that overpriced watered down coffee.
Bitcoin fixes this
Bitcoin solves this problem by using a decentralised network of computers to verify transactions. This means that there is no central authority that can be trusted to fulfil their obligations. Instead, the network itself is responsible for ensuring that transactions are valid and that payments are made.
This makes Bitcoin a much more secure and reliable way to transfer value than traditional financial systems. It also means that there is no counter-party risk, which can save people a lot of money.
For example, if you want to send money to someone using a traditional bank, you have to trust that both banks involved will remain in operation or lose your money. If the bank does go bankrupt, has liquidity issues, has technical issues, has a bail-in or is hacked, you could lose access to your money, lose some of your money, or worse, lose all of your money.
On the flip side, if you send money to someone using Bitcoin, you do not have to worry about this risk. The Bitcoin network is secure and reliable, and there is no central authority that can go bankrupt. Once a transaction is in the mempool, it’s only a matter of time before miners add it to the next block.
This is just one of the many reasons why Bitcoin is a revolutionary technology. It has the potential to change the way we think about money and finance.
Bitcoin the asset versus Bitcoin the network.
Another advantage of Bitcoin is that it is programmable money, and the asset involved is purely digital; this allows users to move funds around in different ways. While the Bitcoin blockchain is one method of moving Bitcoin from one user to another, the Lightning Network is a second-layer payment protocol that operates on top of the Bitcoin blockchain. It allows for fast, cheap, and trustless payments between parties.
Accessing this network is easier said than done.
- You will need to run a Bitcoin full node.
- Run a Bitcoin Lightning Node.
- Create a Lightning wallet, fund it with Bitcoin.
- Broadcast an on-chain transaction to fund the Lightning wallet.
- Create a Lightning channel.
- Ensure you have inbound and outbound capacity, and you are ready to go.
There is a lot of time, cost and technical expertise involved in setting up Lightning, and this has proven a barrier to entry. While there are many different Lightning wallets available, both custodial and non-custodial yet, the vast majority of Lightning Network users are opting for custodial services. A behaviour that seems antithetical to the idea that Bitcoin should remove counter-party risk.
Custodial wallets are managed by a third party, while non-custodial wallets are controlled by the user. So why would users want to trust businesses or individuals with their funds?
The simple answer is it’s convenient.
When you use a custodial lightning wallet, all you need to do is sign up.
The complexity of running it yourself and keeping the channels balanced and your node constantly synced are removed, and all you need to concern yourself with is the balance on your screen.
When going custodial, all you need to do is:
- Choose a custodial Lightning wallet.
- Create a new wallet (sometimes this requires an email or phone number as the unique identifier).
- Fund your wallet with Bitcoin.
- You’re ready to go.
People use custodial Lightning wallets because they are easier to use, cheaper to get started, and there are no maintenance costs involved. With a custodial wallet, you do not need to worry about managing your own private keys or balancing your channels.
The wallet provider will take care of that for you, and while they might do their best, custodial wallets are less secure than non-custodial wallets. If the wallet provider is hacked, their Lightning node goes down or worse; they rug pull you; those funds are now unavailable or lost for good.
Non-custodial Lightning wallets are more secure than custodial wallets since you control your own private keys and maintain signing rights. However, non-custodial wallets are more difficult to use, and if you don’t know what you’re doing, you can end up losing funds or waste time having to troubleshoot failed payments and channel rebalancing issues.
The prevalence of custodial wallets
To give you an idea of how popular custodial wallets are for Lightning use cases, we can look to Nostr adoption. Nostr users can send each other satoshis through the zap function provided by most clients, and these payments are routed through the Lightning Network.
Users can also enable their profile to receive satoshis using a Lightning Address, and looking at Lightning Address users; you can see over 90% of users have opted for custodial wallets. The vast majority of these are micro-payments, with a few outliers using it to send larger amounts.
If we have a look at the average zap amount, it hovers around roughly 17 – 30 satoshis on most days, with a peak of 250 satoshis, hardly amounts that anyone would miss if they were rugged by a custodian. Users are looking for the experience with the lowest friction and are willing to give up custody for it when amounts are small enough, and custodial wallets provide a great onboarding experience.
Users clearly value features like:
Ease of use
Custodial wallets are typically much easier to use than non-custodial wallets. They do not require users to manage their own private keys, and they often offer features like auto-routing and channel management.
No technical issues
You don’t need to be experienced in the operations of Bitcoin or Lightning Network to interact with your balance and the wider Bitcoin network.
Custodial wallets already have liquidity sorted, so you can start to send and receive as much Bitcoin as you like without any issues.
Drawbacks of custodial wallets
However, there are also some drawbacks to using custodial wallets.
Lack of control
With a custodial wallet, users do not have full control over their Bitcoin; you’re reading a balance from their database, and you can request funds be moved on Lightning rails. This means that users could be locked out of their wallets should the provider go out of business or be hacked.
Custodial wallets typically charge fees for their services. These fees can be higher than the fees charged by non-custodial wallets, and you are at the mercy of how they change their fee structure.
Custodial wallets are centralised services. This means that they are subject to the whims of the wallet provider or regulations of the country in which they are incorporated.
Should you use custodial wallets?
Ultimately, the decision of whether or not to use a custodial wallet is a personal one. There is no right or wrong answer. However, it is important to weigh the risks and benefits of custodial wallets before making a decision.
Here are some additional considerations for Lightning users when choosing between custodial and non-custodial wallets:
Amount of Bitcoin to be stored
Custodial wallets are generally considered to be less secure than non-custodial wallets. If you are going to use these services, you need to manage your exposure; if it’s only a few satoshis, it might not be harmful to you should you lose those funds, but if you’re starting to manage large amounts, you might want to move a portion of your balance on-chain and de-risk.
Your technical expertise
Custodial wallets are far easier to use than non-custodial wallets. If you aren’t comfortable with managing channels, private keys, or nodes, then you may want to consider using a non-custodial wallet.
Diversify your balance
If you are apprehensive about running Lightning, your next option would be to distribute your balance among different LSPs or Uncle Jim nodes that will manage your balance on your behalf. This way, if one of your wallets goes down, you still have access to some of your funds.