Non-Custodial, Custodial, or Embedded Wallet? Key Considerations for Digital Asset Custody Providers

Choosing the right wallet infrastructure impacts security, compliance, and operational efficiency - whether you're managing institutional funds, Web3 applications, or consumer-facing crypto services.

Wallets are more than just storage mechanisms - they determine who controls private keys, how assets are secured, and whether the provider must comply with global financial regulations. The three primary models are:

Custodial Wallets: Third-party-controlled solutions, common among regulated financial institutions.
Non-Custodial Wallets: User-controlled solutions that prioritize decentralization and security.
Embedded Wallets: Hybrid solutions that integrate seamless UX with varying levels of custody.

Different wallet structures directly impact security, user responsibility, and regulatory oversight. Below is an analysis of how the wallets function within major compliance frameworks like MiCA (EU), SEC (U.S.), FATF (global AML), and banking regulations like Basel III.

Custodial Wallets

🔹 Definition: A third party (custodian) manages private keys on behalf of users. This model is common among institutions, centralized exchanges, and enterprise clients requiring regulatory compliance.

Security Model

Cold Storage & HSMs: Assets are stored in air-gapped hardware security modules (HSMs) for institutional-grade protection.
Multi-Party Computation (MPC): Some providers use threshold cryptography to split key control across multiple entities.
KYC & AML Integration: Transactions are monitored for suspicious activity and regulatory reporting.

Custodial wallet providers must comply with strict financial regulations, depending on jurisdiction:

About risks

❌ Centralization risk – If the custodian is compromised, all client assets are at risk.

❌ Regulatory exposure – Subject to strict reporting, audits, and operational oversight.

❌ Counterparty risk – Users must trust the custodian’s security and solvency.

Non-Custodial Wallets

🔹 Definition: Users retain full control over private keys, eliminating the need for intermediaries. This model aligns with DeFi, Web3 applications, and retail self-custody solutions.

Security Model

Hierarchical Deterministic (HD) Wallets: Use BIP-32, BIP-39, and BIP-44 for structured key generation and backups.
Multi-Signature & MPC-Based Key Sharding: Some advanced non-custodial wallets distribute key control for added security.
Smart Contract-Based Wallets: Newer solutions use ERC-4337 account abstraction to enhance key recovery and user experience.

While non-custodial wallets are generally not subject to direct financial regulations, some compliance risks still apply, especially when integrating fiat on/off-ramps:

About risks

❌ User responsibility – Losing the private key = total loss of assets.

❌ Smart contract vulnerabilities – If wallet logic is on-chain, it is exploitable.

❌ Regulatory uncertainty – DeFi wallet providers may face future compliance mandates.

Embedded Wallets

🔹 Definition: A hybrid model that integrates seamless user experience while varying degrees of key management delegation.

Security Model

Threshold Signature Schemes (TSS): Splits key control between the provider and user to reduce risks.
Biometric Authentication (WebAuthn): Some wallets use device authentication instead of traditional keys.
Cloud-Encrypted Key Storage: Some solutions store encrypted key shards in secure cloud vaults.

If the provider retains key control, it may qualify as a custodian under MiCA & SEC rules. FATF Travel Rule also applies if the wallet provider facilitates transactions above regulatory thresholds. MSB Licensing (FinCEN) may be required if the provider enables fiat-crypto conversions.

Which Model Fits Your Business? At Scalable Solutions, we are prepared to any use-case and ready to provide a best-tailored solution to specific needs - let's talk about it.