How Do Cryptocurrency Wallets Work?
Your crypto wallets don't actually store cryptocurrencies, but instead the rights to use blockchain to send and receive your assets.
A crypto wallet is a software that “stores” your crypto assets, like cryptocurrencies and crypto tokens.
Technically, crypto wallets don’t actually store anything but a pair of digital keys. It is these keys that allow you to access your wealth in crypto, that is recorded on a global distributed ledger, namely the blockchain.
Now, if this sounds too confusing for you, don’t worry. We’ll offer you a much simpler way to think about cryptocurrency wallets.
What exactly is a crypto wallet?
Let’s first consider what a debit card does. Without getting into the details, a debit card contains a metallic chip that an ATM reads in order to know the bank account that the debit card is associated with.
The ATM will then ask the holder to insert a PIN. If the PIN is valid, then the ATM user has access to his or her funds virtually without going to a bank and without communicating with a teller.
Debit cards don’t actually store your money. If you damage your debit card and then replace it with a new one, you will find that your account balance remains unchanged even at the time when the debit card becomes damaged.
This is because the information pertaining to how much money you have in your account is stored electronically in your bank’s private ledger.
Your debit card is only a tool to help the ATM communicate with the bank. If you insert the right PIN for the appropriate account number, and you decide to withdraw cash, the ATM will tell the bank to deduct money from your account.
So, what is the connection between a debit card and a crypto wallet?
Well, your crypto wallet acts like a debit card. The crypto wallet is associated with a pair of digital keys — the public key and private key. The public key is like an account identifier. The private key is associated with the password or PIN that you set up to unlock your crypto wallet.
When you want to send cryptocurrencies to someone, you first unlock your wallet with a password. If everything goes well, your crypto wallet can begin communication with the blockchain (it’s a ledger, but decentralised). When you make a transaction, your wallet tells the blockchain, “Hey, Wallet X wants to send N amounts of crypto to Wallet Y. Please update the ledger accordingly.”
The blockchain will dictate the amount of crypto you have left over, and will dictate the amount of crypto the recipient has now.
In summary, your crypto wallets don’t actually store cryptocurrencies, but instead the credentials to update the blockchain to send and receive money. So, you will need at least one crypto wallet in order to send and receive cryptocurrencies.
Likewise, your private key is NOT the same as your wallet password or PIN. You can change your password or PIN, but you cannot change your private key. This is why you must ALWAYS keep your private key… well.. private.
If anyone has access to your private key, that person can hack into your crypto wallet and send your hard-earned money their way.
Important: Your public key is NOT the same as your wallet address. The wallet address (which still looks like gibberish) will be given to you when you create a new wallet, and you use this address to receive cryptocurrencies.
Hot wallets v. cold wallets — what’s the difference?
A hot wallet has a constant connection to the Internet. A cold wallet can be disconnected to the Internet — i.e. your public and private keys are saved on a device or printed on a piece of paper.
A cold wallet still requires a client software that runs on a desktop computer. However, when not in use, a cold wallet can be taken offline (not connected to a computer). You can still receive cryptocurrencies even if your cold wallet is not connected to the Internet.
Wait, how is that possible?
Remember the debit card analogy? Your cold wallet (or hardware wallet as some may call it) is just a device that contains the account credentials, which enables the client software (the proverbial ATM) to talk to the blockchain — the public ledger that records your ownership of cryptocurrencies.
Which is safer, hot or cold wallets?
It is safer to store large amounts of cryptocurrency in a cold wallet. Because cold wallets aren’t always connected to your device and the Internet, there is a significantly reduced chance of getting your funds stolen from hackers.
One way hackers can steal your private keys is by using malware such as keyloggers (which is commonly and unknowingly downloaded via an email/software phishing attack). Keyloggers can reveal what you type in your device; hackers can use this data to access your hot wallet.
However, cold wallets are a different story. Even if a hacker manages to discover your user credentials, without the physical presence of the hardware, they can’t gain access to your funds.
The only downside is that as cold wallets are not connected to the internet you can’t easily send or spend your crypto. If you are wanting to make frequent transactions it is a trade-off between speed and security.
Other types of crypto wallets
A web wallet is a wallet that is stored inside a website such as an exchange like Binance or Kiwicoin. Storing assets on exchanges or web wallets are necessary for people trading through exchanges, but an unnecessary risk to others who just want to “HODL” — i.e. investing in long-term.
Issues with web wallets are that you do not hold the private keys to your wallet – the exchange does.
In 2014, Mt Gox, a Japan-based exchange that at the time handled 70% of all bitcoin transactions, was hacked. (When we say hacked, Bitcoin itself wasn’t hacked, passwords to access the private keys of the exchange were stolen, allowing the hackers access to their wallets).
This resulted in their users and personal business accounts losing about 740,000 bitcoins (6% of all bitcoin in existence). That equated to 780 million dollars at the time of the heist.
There a several ways that the security of your assets can be compromised when stored on an exchange:
- Your computer is hacked or your lose your password.
- Your exchange’s remote server is hacked.
- Your exchange goes bankrupt.
- The FBI or other authorities seize the exchange servers.
- There is a software bug in your wallet.
- An unauthorised person accesses your smartphone or computer while you are logged in.
A paper wallet is another type of ‘cold’ wallet because it is stored offline and keeps your private key safe so you can access your crypto when required.
To spend the Bitcoin on your paper wallet, you need to open up a hot wallet and ‘sweep’ the address to move the coins from the paper wallet into the new wallet.
Storing a private key on a paper is quite secure but extremely inconvenient in use. Moreover, you will have to enter your private key in one of the wallet types described above to make a transaction.
Which crypto wallet should I use?
The best wallet for you will depend on how much crypto you are storing, how accessible you want it to be, and your own preferences e.g. whether you feel safer with something stored physically or electronically.
Our top three picks for the best crypto wallets are:
1. A high-quality cold hardware wallet like a Ledger Nano, is an excellent option for long term storage. Make sure that you safely store your passphrase, and then even if you lose the physical device you can simply re-install your old wallets on a new Nano. Phew! You can browse the Ledger shop here.
2. If you want to use a hot wallet for frequent sending and management of your portfolio, take a look at Exodus – free a multi-currency wallet that can be found here.
3. If you want both cheap and safe, go DIY with our guide to setting up your own cold storage system.
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Disclaimer: Information is current as at the date of publication. This is general information only and is not intended to be advice. Crypto is volatile, carries risk and the value can go up and down. Past performance is not an indicator of future returns. Please do your own research.
Last updated December 6, 2021