- A cryptocurrency wallet is a piece of software and hardware that stores your private keys, which are used to prove ownership over the coins on the blockchain
- We distinguish between software wallets, hardware wallets and paper wallets, and they all come with certain benefits and drawbacks
- The safest way to store large amounts of valuable cryptocurrency is in a “cold storage” i.e. in wallets not connected to the internet
- Using multiple wallets rather than sticking to one wallet increases the security of your assets
Whether you are completely new to the cryptocurrency space or already an experienced crypto HODLer, you have almost certainly used a cryptocurrency wallet before. But what exactly is a wallet and how does it interact with the blockchain? How do users prove ownership over the coins on the blockchain and which types of wallets exist? In this article we aim to answer all these questions and more, which should help you choose the type of wallet that suits your need the most.
What is a cryptocurrency wallet and why do you need it?
Whether you would like to have a specific cryptocurrency to make purchases, invest, trade, or use it in any other way, you will need a wallet to manage your coins. As opposed to real wallets, cryptocurrency wallets do not contain any physical currency, but rather the cryptographic keys that allow you to access and manage the coins that are recorded on the blockchain. In other words, wallets simply point out which coins on the blockchain belong to you. Cryptocurrency transactions work on the very same principle; when you send coins to another address, you are not actually sending coins themselves, but rather admitting ownership of a set number of coins to another wallet. The current state of ownership is determined based on all past transactions, which are recorded on the distributed ledger – the blockchain.
The blockchain is a giant distributed ledger of all the transactions ever done within it. As new blocks are recognized by the majority of the network’s nodes, the transactions included in these blocks become irreversible. Interestingly, the blockchain does not have a list of all the existing wallets as it is merely storing transaction information. Therefore, if a wallet address has not appeared in a transaction yet, it would not be recorded on the blockchain. In fact, the blockchain cannot even guarantee that all the wallets involved in its transactions exist, which facilitates performing several unique features such as “burning coins” by sending them to non-existent addresses. This option provides a useful way for forever removing coins out of circulation but can also cause lot of damage and stress if it happens accidentally.
Wallet Creation Process
Using specific wallet creation algorithm embedded into the wallet software, anyone can easily create a new wallet address. The utilized cryptographic algorithm generates a pair (or multiple pairs) of public and private keys, along with a wallet address, which is basically a hashed version of the wallet’s public key. As already mentioned, a wallet is not instantly recorded on the blockchain but only appears on the ledger when the first transaction featuring the address is made. Interestingly, wallets can also be created offline and even an offline wallet can receive funds. Nevertheless, users still need to go online or in some other way broadcast the transaction to the network to send their funds.
Public and Private Wallet Keys: What is the difference and why the private ones are so important?
As we mentioned above, a cryptocurrency wallet is basically a pair of linked cryptographic keys: the private and the public wallet key. As their names imply, public keys can be shared with everyone, while private keys should be kept to yourself. If you own a private wallet key you can find your public key, however, determining the private key from the public key is not possible. Public keys are used to create your wallet address, which you provide to other users from who you wish to receive funds, much like a bank account number. Private keys on the other hand are used to verify ownership of the wallet and the funds that are held in it judging by the current state of the transaction ledger. The private keys work on different wallets and software, and as long as you have them, you will be able to access your coins. Because of this securing your private key is crucial in keeping your assets safe, as anyone in possession of a private key can use the coins tied to it.
Three Types of Cryptocurrency Wallets
Two main types of cryptocurrency wallets exist: the software and hardware wallets. In addition, coins can also be stored on printed paper wallets. Each type has several subcategories and they all come with certain benefits and trade-offs.
Software wallets are arguably still the most popular and most frequently used wallets in the cryptocurrency space. Because they are always connected to the internet, we also call them “hot wallets”.
- Web/Online wallets are wallets hosted on websites by different wallet providers, often cryptocurrency businesses such as exchanges. There are several drawbacks of using web wallets, such as relying on a third party to keep your information safe, inability to completely control your funds, as the third party can decide to hold or freeze your funds if they suspect suspicious activity. In addition, the fata is usually stored on cloud servers, which are known to be one of the easiest targets for fraudulent activity. On the other hand, their upside is easy accessibility and the ability to perform different actions, depending on the third party in question (trade, exchange for other currency, invest, bet, fund, and many more). These wallets are most commonly used for trading and should not be used to store large amounts of funds.
- Desktop wallets are often considered as the safest among software wallets. There are programs that you can install on your computer to store your cryptocurrency. They offer different options, depending on the wallet application used, and can be protected in various ways, making them a relatively secure way of storing your coins. The biggest drawback is that they are tied to the device itself and cannot be used without it. Having this in mind, losing access to a desktop wallet or the device itself can be devastating. Therefore, it is highly recommended that you always keep your device protected and have a secure back-up of the private keys or the wallet recovery phase.
- Mobile wallets are wallets that can be used on mobile devices. They come in the form of an app and often offer less features than desktop wallets because of the resource limitations of mobile devices. Furthermore, users of the mobile wallets can suffer from the same issues as those using desktop wallets, so keeping your device secure and your keys backed-up is crucial. Their upside compared to the desktop wallets is higher mobility and being able to access your funds on the go. In addition, these applications often allow you to easily make transactions by using QR codes.
Hardware wallets are wallets that exist in the form of a USB device, or other piece of hardware that connects externally to a computer, where a piece of software is used to manage its contents. Because they allow for funds to be kept offline, we use the term “cold wallets” or sometimes “cold storage”. Although transactions still need to be made online, they do not have any online storage, and have all the needed access information on themselves, providing an excellent level of protection. Apart from that, they usually have a PIN code, so just having them is not enough to access the information, you would need to unlock them as well. Various hardware wallets offer different options like Bluetooth connectivity, UI with a display or touchscreen. The wallets also differ in terms of compatibility with other wallets so you should thoroughly examine all the features before purchasing your first hardware wallet.
They are considered the best way of keeping large amounts of crypto safe, and generally resemble regular wallets the most, having in mind that you need to have the physical device itself to use the funds. Just do not lose it! Most popular hardware wallets manufacturers include Trezor, Ledger and Cobo. Hardware wallets need to be purchased, while all the other wallet types are usually free. However, the cost of a hardware wallets is minimal compared to the potential financial consequences because of the loss of you coins.
Paper wallets are in many ways like hardware wallets, but instead of a USB device, the needed information is printed out on a piece of paper, usually in a form of an address or QR code. Same as with hardware wallets, specific software needs to be used for their creation and management. Paper wallets are also considered an extremely safe and undoubtedly cheaper way of storing your digital assets, but they do come with several disadvantages and risks. First, the creation and use of paper wallets can be confusing for users unfamiliar with the key system. However, even the tech-savvy holders are still exposed to issues with reading the information printed on a paper wallet, due to damage, or even software issues with the reader or the printer that wrote the information. To eliminate or at least minimize the risk of damage, wallets where the data is engraved in metal or other durable material have emerged.
The Bottom Line
Wallets come with various features and there is a wide choice of wallet software currently available, so make sure to explore all the options before settling for one. Having all this in mind, what you plan to do with your coins greatly affects what kind of wallet you need. For most types of trading, having a web wallet is necessary, as using exchange’s services is mostly done on wallets on their servers. On the other hand, cold storage is a perfect way of keeping large amounts of coins safe, either as savings, or just having a main wallet from which you divert smaller amounts of coins to different hot wallets. Whatever the case, when using a wallet, updating relevant software, and keeping backup is very important, especially when storing larger amounts of coins.
Edward is a finance expert that experienced the 2007 stock market crash first hand. In 2010, he discovered Bitcoin and has been a cryptocurrency advocate ever since.