From banks to exchanges, what happens to your money?
From banks to crypto exchanges, there's lots that can happen when you transfer money to a custodian. But if you think the job of a bank is to store your cash, you might be in for a surprise. Here's our explainer about what happens to your money when you transfer it to a bank or to a (good!) crypto exchange, in simple terms.
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What happens when you transfer money to a bank
Deposits are not always what they seem
To keep things super simple, a bank's primary role is to act as an intermediary between depositors and borrowers. It does that by pooling funds from individuals or entities that deposit money and then lending these funds to entities who need loans.
The amount banks pay for deposits and the income they receive on their loans are both called interest. The interest they charge their borrowers on loans is normally higher than the interest they pay back to depositors. The difference between the two, known as the Net Interest Margin, is meant to be positive and generate a net profit for the bank.
So, when you deposit money into a bank account, you basically become that bank's creditor. And just like any other borrower, banks expect to repay their loans over time, but typically not all at once. This means that when there's a crisis of confidence, when the depositors are afraid the bank might not be able to repay in time what they owe them, a sudden, unexpected spike in withdrawals can happen. That's called a 'bank run'.
To prevent bank runs and the effect they might have on the economy at large, a set amount of everyone's deposits is now usually insured by local financial authorities. Due to the recent banking crisis in the U.S., the question of when this insurance gets triggered, what amount it covers, and what its long term effects on banks' incentives are has become a matter of intense controversy.
How bank loans work
When you apply for a loan at a bank, you're asking to borrow money. Therefore, the bank will review your creditworthiness and loan repayment ability. If you're approved, the bank will lend you the money with an agreement to pay it back with interest. This interest is the bank's profit from providing the loan.
Loans can come in many forms, such as personal loans, mortgages, or business loans, and each has its terms and conditions. The bank typically requires collateral or a credit check to secure the loan and reduce risk. Repayment schedules and interest rates can vary depending on the type of loan and the borrower's creditworthiness. When it comes to borrowing, you should consider the terms of a loan and ensure that you can afford to make the payments before agreeing to borrow money from a bank.
See the parallel now? Depending on how much your deposit is insured, it can more or less resemble a loan – except you're the loaner! In cases like this, it can make sense to think like banks do when they evaluate their customers' creditworthiness and evaluate how much risk the deposit might come with.
What happens when you move money to a (good!) crypto exchange?
Trading is the main activity people use exchanges for, but it's not the only choice you have. When moving money to a crypto exchange, you can decide between at least three other options:
- Keeping it on the exchange (third-party custody)
- Storing it yourself (self-custody)
- Putting it to work (staking)
What's the difference between third-party custody and self-custody?
In crypto people sometimes speak of custodial versus non-custodial wallets but that's misleading. "Custody" really means storage, so all crypto wallets are custodial. The question is: Who does the custody/storage of the wallet's private keys?
So it's better, instead, to distinguish between third-party custody and self-custody:
- Third-party custody means delegating custody of one's funds to someone else
- Self-custody means managing the custody oneself
Each of these two options comes with different benefits and tradeoffs.
Third-party custody
When you let tokens sit on an exchange, you task the exchange with running a wallet to hold and manage your crypto on your behalf. In this case, you don't have control over that wallet's private keys – and the exchange is responsible for securing your assets. This means your funds might be exposed to counterparty risks, such as hacks, bugs, or other incidents putting your assets in jeopardy.
Self-custody
With a self-custody wallet, on the other hand, you have sole ownership of your private keys, giving you full control over your assets. Self-custody wallets also usually require little to no personal information, which better protects your financial privacy. With great power, however, comes great responsibility: If you lose your private keys and seedphrase, it might be very difficult to recover access to your funds.
How much of one's crypto stash to put into third-party custody or into self-custody will therefore heavily depend on everyone's specific circumstances – there's no one-size-fits-all solution!
Putting your crypto to work, in your own terms
Contrary to banks, (good!) crypto exchanges will offer you the option to simply store your funds, without investing or loaning them. They should only put your assets to work if you explicitly ask them to.
Oftentimes, the option they will offer will revolve around staking. In very simple terms, staking means holding a certain amount of tokens in order to participate in its blockchain's consensus mechanism. By holding tokens, stakers help secure the network and can earn additional tokens as a reward. Staking is often seen as a more affordable way to participate in protocols than mining, which requires expensive hardware and high electricity costs.
Staking, however, like other ways to put money to work, comes with risks: The protocol might face a technical issue, the price of the token might dip, and more. So the decision of staking or not must be made with the knowledge of the risk profile of the asset, its blockchain, etc. In turn, whether to stake and how much should also hinge on all the other relevant specifics of your situation, such as how much of your portfolio is in crypto, what amount of risk you want to take, etc.
In short: Putting money to work always involves some degree of risk and crypto's great innovation is to allow you to clearly decide how much risk you want to take. This is why we're doubling down our efforts to bring financial education to everyone, so our customers can choose the options that best fit their needs – and only take the risks they're comfortable taking.
NOTHING IN THIS ARTICLE IS A SOLICITATION TO BUY OR SELL DIGITAL ASSETS. OKX DOES NOT ENDORSE ANY PARTICULAR DIGITAL ASSET OR STRATEGY. DIGITAL ASSETS HOLDINGS INVOLVE A HIGH DEGREE OF RISK, CAN FLUCTUATE GREATLY ON ANY GIVEN DAY, AND MAY EVEN BECOME WORTHLESS. YOU SHOULD CAREFULLY CONSIDER WHETHER TRADING OR HOLDING DIGITAL CURRENCIES IS SUITABLE FOR YOU IN LIGHT OF YOUR FINANCIAL CONDITION. OKX DOES NOT PROVIDE LEGAL, TAX, INVESTMENT, OR OTHER ADVICE. PLEASE CONSULT YOUR LEGAL/TAX/INVESTMENT PROFESSIONAL FOR QUESTIONS ABOUT YOUR SPECIFIC CIRCUMSTANCES.
