A custodial wallet is used for the digital safekeeping of fiat and cryptocurrencies; a theoretically trusted third-party (custodian) is empowered with their own private key to manage and secure the wallet on behalf of the wallet holder. In many ways, a custodial wallet in the blockchain industry is similar to how an airline handles the custody of a traveler’s frequent flier miles. The traveler never actually takes possession of the miles as though they were a currency. Instead, the airline holds those miles on the traveler’s behalf until the traveler decides to transact with those miles for air travel or any other goods and services that the airline offers.
In the blockchain industry, custodial wallets are typically mentioned in the context of wallets that are maintained by centralized cryptocurrency exchanges like Binance or Coindesk on behalf of their retail investors. For example, after a Binance user trades fiat currency (e.g., US dollars) for cryptocurrency, the exchange stores the resulting cryptocurrency in a wallet that is maintained on behalf of that user (the account holder). Prior to making that trade, the account holder must load their wallet with enough fiat currency to cover the desired amount of the trade as well as any exchange fees. Bank wire transfers are one way that account holders load their wallets with fiat (in preparation for a trade of fiat for crypto).
A custodial wallet is therefore a wallet that another entity maintains for the user. It’s akin to trusting a personal assistant — another human being — to keep custody of your physical wallet (the one that has your driver’s license, credit cards and cash). Whenever you need to exchange some US dollars for euros, the assistant runs off to a currency exchange, swaps some euros for the US dollars in your wallet (which is in her possession), and then brings it back to you. The cryptocurrency exchange that maintains your custodial wallet should always be there, like a personal assistant, waiting to swap any of the currencies it supports.
Working with exchanges and custodial wallets has proven risky for some customers. Going back to the idea of your personal assistant; if he has custody of your wallet, there’s not much you can do if he disappears. This is one reason why, in addition to custodial wallet technology, there is also non-custodial wallet technology.
It’s important to understand that cryptocurrency exchanges are not the only entities that maintain custodial wallets. Just about any enterprise can provide custodial wallets to its customers. For example, similar to how airlines and credit card companies keep track of loyalty points for of their customers, a business that uses non-fungible tokens (NFTs) as a means to ongoing customer engagement and loyalty might also provide those customers with custodial wallets in which to keep those NFTs. Similar to how airlines and credit card companies seamlessly handle the custody of their customers’ loyalty points, custodial wallet technology makes it possible for enterprises to build frictionless customer experiences for their customers. As an alternative, those same enterprises could allow their customers to use non-custodial wallets, which enable customers to be in full control of the wallet. However, the burden — essentially friction to adoption and usage — is then on the customer to configure and manage those wallets on their own.