LESSON 8.1 · NOTES · BASICS
Whoever holds the key is in control: wallets, exchanges and DEXs
Someone lost a token without losing their seed phrase and without sending to the wrong address: they simply signed an approval. We look at what a key is, how an exchange differs from a wallet, and what you pay for the convenience of one and the freedom of the other.
Three takeaways
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Whoever holds the key is in control. That’s why a withdrawal on an exchange is a request, and in your own wallet it is an action.
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An exchange gives you speed, an order book and support in exchange for counterparty risk. A wallet gives you full control in exchange for irreversibility, gas, and having no one to help you.
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On an exchange, someone else’s decision lets you down; in a wallet, your own does. Frozen accounts and suspended withdrawals versus a signature you didn’t read.
1. The key and the seed phrase
A coin is an entry in a ledger: an address and an amount (lesson 1). Whoever holds the key can change that entry. The key is the right to sign a transfer from an address. The network doesn’t ask who you are, whose account it is or whose name it’s in. It checks one thing: the signature matches the address, so the transfer goes through.
A wallet doesn’t store coins; there is nowhere to store them, they are in the ledger. A wallet stores the key, and nothing else.
A seed phrase is the 12 or 24 words shown to you when you create a wallet. It is not a password. All your keys and all your addresses on every network are derived from these words. A password can be changed; a seed phrase can’t. Whoever has seen it has your whole wallet, and you won’t lose access: you won’t even notice that the wallet is no longer only yours.
2. Two kinds of wallets
| Non-custodial | Custodial | |
|---|---|---|
| Who holds the key | you | someone else, usually an exchange |
| Examples | a phone app, a browser extension, a hardware wallet | an exchange account |
| Withdrawal | an action: you sign | a request: the exchange signs |
| If you make a mistake | no one can help, there is no “forgot password” | support can sometimes fix it |
A hardware wallet is a separate device that signs internally and never lets the key out.
On an exchange, your balance is a row in a database, and a trade is an edit to two rows (lesson 2). Now you can see why: the exchange holds the key, so it has no reason to go to the network to rewrite its own table. You submit the withdrawal request, but the exchange signs the transaction.
3. The exchange: what it gives and what you pay
An exchange gives you an order book in one place, instant trades, instant transfers between spot and futures, leverage and support. For arbitrage, the main thing is that both legs are in one interface and can be closed in seconds.
You pay with one thing: counterparty risk. It comes in three forms.
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It won’t give it back at all. Bankruptcy, founders draining funds, a hack: Mt.Gox, FTX. FTX customers did eventually get their money back, but in dollars, at the price on the day of the bankruptcy. Bitcoin has grown many times over since then. The dollars came back; the coins didn’t.
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It won’t give it back right now. Withdrawals of a coin are suspended: maintenance, a network problem, congestion. The money is safe, but the arbitrage pair is stuck and the spread is slipping away. That’s why it was on the checklist in lesson 8.
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It won’t give it back to you. Exchanges check where incoming coins came from. A coin with a bad history can freeze your whole account, even if you didn’t buy it and someone simply sent it to you.
Proof of reserves shows that the exchange has the assets. It doesn’t show how much it owes. It’s a snapshot, not an audit, like stablecoin attestations (lesson 6).
4. DEX: trading directly on the blockchain
A decentralized exchange is not a company but a program on the blockchain, a smart contract. You don’t deposit anything into it; you connect your wallet. The site sees your address but can’t move anything. The coins stay with you until the moment of the trade.
A trade is a transaction you sign yourself. The network executes it, and the coins swap places in that same moment. No deposits, no withdrawals, no sign-up and no limits. A withdrawal here is an action, not a request.
Not every DEX is built on pools: some look just like an exchange, with an order book, perps and leverage. But there too, it’s your key that’s in control, not a company account.
The pool: your own trade moves the price
Most of the time on a DEX you trade not against a person but against a pool. A pool is two coins that someone deposited into a contract, and the price comes from their ratio. When you buy, you add one coin to the pool and take out the other, the ratio shifts, and the price moves against you. The bigger your amount relative to the pool, the worse your price.
An example on a classic pool (the x·y = k formula), ETH at $2,000:
| Pool | Trade | Trade as share of pool | Pool after the trade |
|---|---|---|---|
| $2,000,000 (1,000,000 USDT + 500 ETH) | $20,000 | 1% | 1,020,000 USDT + 490.2 ETH |
| $2,000,000 | $200,000 | 10% | 1,200,000 USDT + 416.7 ETH |
| $100,000 (50,000 USDT + 25 ETH) | $20,000 | 20% | 70,000 USDT + 17.9 ETH |
The same $20,000 in a small pool is 20% of it and moves it harder than $200,000 moves the big one. This is the same slippage as in lesson 3, only calculated from the size of the pool instead of the order book. In lesson 8 we looked at order book depth rather than total volume. On a DEX the rule is the same: look at pool size. In a small pool, nothing is left of an attractive spread figure.
To run your own numbers, use the pool slippage calculator attached to this lesson.
Gas
You pay gas for every transaction, and only in the network’s native coin:
| Network | Gas is paid in |
|---|---|
| Ethereum | ETH |
| BNB Chain | BNB |
| Solana | SOL |
Without gas, a wallet can’t do anything, even if it holds a million in USDT. And gas is charged even when the transaction fails.
Sandwich attack
On most networks a transaction first lands in a shared queue and only then in a block, so it is visible before it executes. Bots make a living from this. Say you allowed 3% slippage. A bot buys right before you, pushes the price up by exactly those 3%, and sells right after you. You end up squeezed between two of its trades, which is why it’s called a sandwich attack. Your tolerance is its profit. Set the tolerance as low as will still go through.
5. The wallet: what you pay for freedom
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Everything is irreversible. Sent to the wrong address, on the wrong network, confirmed the wrong thing: there is no undo button and no one to complain to. The network did exactly what you signed.
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Wallets get drained not by hacks, but by signatures. For a swap service to sell your token, you give the contract permission to spend it. By default this is often unlimited in amount and time. That is normal; all swapping works this way. But an approval requested by a fake site looks exactly the same. You sign, and anyone can take your token at any time, without you. You didn’t make a transfer; you just granted the right.
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A signature without gas can also be an approval. “Free” and “safe” are not the same thing here.
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A hardware wallet protects the key, but not from your own signature. The key physically never leaves the device, but you’ll press the confirm button yourself.
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A coin’s name means nothing. Anyone can issue a token with any name, and it costs next to nothing. Find a coin by its contract address from an official source, not by its name in a search.
“Unlimited amount” is a default, not a rule. In the wallet window, before signing, you can set the approval amount manually. And an approval you’ve already given can be revoked at any time.
6. Where this shows up in arbitrage
| Pair | Where the legs are | Risks |
|---|---|---|
| Exchange — exchange | both in someone else’s custody | fast and convenient, but depends on both exchanges working and withdrawals being open |
| Exchange — DEX | one on an exchange, the other under your own key | no closed withdrawals or frozen accounts, but gas, block time, the pool price and bots in the queue |
We’ll go through the exchange — DEX pair in the practical track.
On capital: in lesson 8 we decided which exchanges to keep money on. The broader question is how much to keep on exchanges at all. On the exchange: your working amount, the money you trade with. The rest: under your own key. An exchange is a working tool, not a safe.
Checklist
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Seed phrase on paper, and not next to your phone. Not in notes, not in photos, not in the cloud.
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Two wallets: a working one with a small amount that signs on websites, and a vault that never signs anywhere.
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Native coin for gas loaded before your first trade. Without it you can’t even get your own coins out.
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Review the approvals you’ve given to contracts and revoke everything you no longer use. Ten minutes that close off the most common way wallets are lost.
Terms
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Key (private key): the right to sign a transfer from an address. Whoever holds the key controls the coins.
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Seed phrase: 12 or 24 words from which all of a wallet’s keys and addresses are derived. It can’t be changed.
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Non-custodial wallet: a wallet whose key you hold.
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Custodial wallet: a wallet whose key someone else holds, usually an exchange.
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Counterparty risk: the risk that the party holding your money won’t give it back at all, right now, or to you.
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Proof of reserves: an exchange’s report on what assets it holds. Its liabilities are not visible in it.
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DEX: a decentralized exchange, a program on the blockchain. You sign the trade yourself.
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Liquidity pool: two coins in a DEX contract. The price comes from their ratio.
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Slippage: the difference between the price before the trade and the average price the trade was filled at.
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Gas: the network’s fee for a transaction, paid in the network’s native coin.
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Slippage tolerance: how far the price may move from the expected one and still let the transaction execute.
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Sandwich attack: a bot buys right before your trade and sells right after it, pocketing the difference within your tolerance.
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Approval (approve): the right you give a contract to spend your token.
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Contract address: a token’s unique address on the network. It’s how you tell a real coin from a fake, not by its name.
Check yourself
Why is a withdrawal from an exchange a request rather than an action?
The exchange holds the key. You submit the request, but the exchange signs the transaction, and it may choose not to.
Does a wallet store coins?
No. Coins are entries in a ledger. A wallet stores the key.
FTX customers got their money back. Why did they still lose?
They got dollars at the price on the day of the bankruptcy. The coins have grown many times over since then.
The same $20,000 trade in a $2 million pool and in a $100 thousand pool. Where is the price worse?
In the small one: there the trade is 20% of the pool, not 1%, and it shifts the coin ratio harder.
A wallet holds a million in USDT and zero native coin. What can you do?
Nothing: no transfers, no swaps, no withdrawals. Gas is paid only in the network’s native coin.
Why set a minimal slippage tolerance?
The tolerance is the bot’s profit in a sandwich attack. The bigger it is, the more the bot can take.
Will a hardware wallet save you from a fake site?
No. It protects the key from theft, but you’ll sign the approval yourself.
Next lessons: three hands-on walkthroughs. Getting started on an exchange, getting started with a wallet, and bridges: how to move a coin from one network to another without losing it along the way.
This material is for educational purposes only and is not investment advice. Any trading decisions are yours alone and at your own risk.