Crypto wallets are a unique way to store your cryptocurrencies to keep them safe and secure. With much of the recent turmoil surrounding crypto exchange platforms, traders seek alternatives to keep their valuable assets private. But what is a crypto wallet? How does a crypto wallet work? There are many crypto wallets to consider, and no “one size fits all.” Every trader has different goals and storage needs. The best crypto wallet for one trader may not work for others. In this article, we’ll dive into the details of the different wallets and how they work to secure cryptocurrency assets.
What is A Crypto Wallet?
Provide a set of unique public and private keys.
Enable users to buy, sell, and trade when connected to a third-party application
Complete transactions within the blockchain.
Wallets can also connect to decentralized applications (dApps) to perform trades and other blockchain transactions.
Crypto wallets come in a few different forms. Sometimes, wallets are called “hot”, “cold”, or “warm”. “Custodial” or “non-custodial.” Some wallets work better for multiple owners and require multiple signatures. In the following paragraphs, we’ll discuss these crypto wallet options and a few others to help you understand how crypto wallets work.
Private and Public Keys
To understand how crypto wallets work, it’s essential first to understand what private and public keys are. Every wallet has a public key and a private key. Keys are lengthy, alphanumeric sequences, typically more than 25 characters long:
The public and private key system ensures the secure delivery and receipt of transactions. This key system includes three features: public key, private key, and wallet address.
The Public key is a cryptographic code used mainly for dissemination. Users can receive messages, tokens, or coins by using the public key. When these assets are sent using a public key, they are then converted into a code that can only be decrypted by using the corresponding private keys. Those that don’t have the right private keys would only see a message like the example above.
Public keys allow anyone to verify the legitimacy of transactions from the key's corresponding private key. The sender signs a transaction with their private key, and anyone can verify this signature (thus ensuring the integrity of the transaction) using the sender's public key.
While public keys are used to encrypt a transaction, private keys are used to decrypt them. This way, only the owner of private keys can decipher the message or receive the assets. This is why it is vital to secure private keys as safely as possible, ideally offline. Once a user loses access to their private keys, it’s possible that they could also lose all of their assets in that wallet.
The private key acts as a digital signature, unlocking or finalizing the transaction on the blockchain. Private keys are akin to a pin code on a debit card but much harder, in fact, nearly impossible, to hack. And the wallet address is actually a hashed version of the public key. That’s why every time you receive assets, the wallet address is different.
A wallet address is needed to receive assets. It consists of a set of 25-35 letters and numbers that are randomly generated each time a deposit takes place. A wallet address is a hashed version of a public key. In other words, it is a simpler and shorter version of the public key.
Where Does the Crypto Wallet Store My Crypto?
Crypto wallets do not store cryptocurrencies but actually hold the public and private keys. These keys make it possible to initiate and verify transactions on the blockchain.
Now that we understand the function of public and private keys and their importance to crypto wallets, let’s discuss the difference between “hot,” “cold,” and “warm” wallets below.
Hot, Cold, and Warm Wallets
Traditional investors of physical assets may keep their valuables locked up in a vault or a safe. On the blockchain, these “vaults” can be “hot”, “cold” or “warm.”
A hot wallet is a crypto wallet always connected to the internet. Since the private keys are stored on a program connected to the internet, hot wallets make it convenient to buy, sell, and trade crypto almost instantly. While holding private keys in a hot wallet is convenient, it does pose some risks for investors.
Contrastingly, a cold wallet is a cryptocurrency storage system not connected to the internet. Ideally, only the owner of the cold wallet would have the private key, making it virtually impossible for attackers to access that wallet. While it provides more security than a hot wallet, cold wallets may be less convenient as they’re not readily connected to the internet.
Warm wallets offer the speed and convenience of a hot wallet but with a bit more security. They are often based on downloadable software or apps instead of a web-based exchange platform. Additionally, warm wallets rely on 12-digit passcodes or PINs for identity verification whereas hot wallets use a two-factor verification process involving the users' personal information.
Pros and Cons
Hot and cold wallets each have pros and cons of their own. For quick and convenient transactions, hot wallets provide an easy way to interact within the blockchain. However, both the public and private keys of a hot wallet are stored online, making them susceptible to attacks. In this case, traders ideally will keep smaller amounts of crypto only used for active trading in hot wallets.
Cold wallets are offline. Being offline provides inherent security for cold wallets that don’t exist with hot wallets. While hot wallets offer almost instant access to crypto funds, a cold wallet must be connected to an internet-abled computer.
Another factor, hot wallets are generally free, while cold wallets usually run around $200. Given its level of security, cold wallets may be well worth the extra cost. I should note that there are free cold wallet options as well, such as paper wallets or wallets on a device that is kept offline, but paper wallets are generally ill-advised.
Overall, “hot” basically means that the wallet is always online, making assets potentially susceptible to hacking, while “cold” refers to private keys being offline at all times until the owner connects the wallet to the internet. Now that we understand the concept of “hot” and “cold” wallets let’s move on to the multi-signature wallets below.
Going Beyond Hot, Warm, and Cold Wallets
Now that we understand the purpose of public and private keys and the difference between hot and cold wallets, let’s discuss the unique features of a multi-signature wallet. Multi-signature wallets add an additional layer of security for transactions to take place. These wallets are beneficial with shared crypto funds, requiring multiple signatures.
Multi-signature wallets are similar to joint bank accounts. All private key holders can view and authorize transactions in the wallet. Multi-signature wallets can offer users access to funds in a business or partnership scenario where multiple authorizations are required. Additionally, if one of the users loses or damages the private keys, funds can still be recovered using the other user’s private key.
A Multi-signature wallet can also be used by a single user on multiple devices. Single users can take advantage of the extra layer of security in this way. Whenever a transaction is initiated, it must be authorized across multiple devices to be complete. These devices include a phone, computer, or hardware wallet.
Overall, multi-signature wallets are useful when funds belong to multiple parties, or a single user would like an extra layer of security. Access is granted only to those that hold the private keys. Therefore, wallet holders must keep their private keys secure and in a safe place offline.
Next, we’ll discuss another type of wallet: the custodial vs non-custodial wallets. Keep reading to learn more.
Custodial vs. Non-Custodial
If you’re familiar with wallets for crypto like Coinbase.com and Binance, they are well-known examples of custodial wallets. The main feature of custodial wallets is that a third party, like Coinbase.com, holds onto users’ private keys. When keeping funds in a custodial wallet, users trust the platform to safeguard the private keys to their crypto assets. While these platforms require multiple authorization methods sometimes, how secure funds are and if they “really” belong to the user is still questionable. As the saying goes, “Not your keys, not your crypto.”
Custodial wallets are convenient. Traders can instantly buy, sell, and trade crypto. Custodial wallets don’t require extra effort to type in multiple seed words and connect to the internet as non-custodial wallets do. In essence, a custodial wallet provides a shortcut to trading and securing transactions.
A disadvantage that comes with custodial wallets is the lack of anonymity. Most custodial wallets require users’ personal information under Know Your Customer (KYC) and Anti Money Laundering (AML) features. For users that wish to keep their personal information offline, this may be a deal breaker.
Contrastingly, a non-custodial wallet gives its owner complete control over the account, while its private keys are just that, private. Only the owner of the non-custodial wallet’s private keys can initiate and finalize transactions. The Ledger Nano is an example of a non-custodial wallet.
Custodial wallets are a great option for beginner and less advanced traders to get a start in trading. The responsibility of securing private keys may be daunting for someone just starting out with cryptocurrency trading. Resetting passwords is relatively simple with custodial wallets. If users lose or forget their passwords, they can easily regain access, whereas non-custodial wallets do not provide a way to regain access once private keys are lost.
Multi-Party Computational (MPC) wallets are relatively new and up-and-coming crypto wallets that offer a unique kind of security for private keys. While the previously mentioned wallets store private keys online or offline, MPC wallets actually store private keys in “shards.” In other words, each party does not hold an individual private key, per se. Instead, they only have a part of the key, called a “shard” or “key share.” MPC wallets attempt to solve the security issues with crypto wallets by redundantly distributing ownership of private keys between parties. With MPC wallets, the only way to complete a transaction is for all parties to apply their key shares to the transaction. The key share acts as a digital signature once all parties have correctly input the information. Think of it as separate pieces of a puzzle that must come together in order for a transaction to be complete.
While online attacks are still possible, MPC wallets make the process more complex. Hackers would need to attain not just one set of private keys but all key shards in an MPC wallet to access funds and complete transactions.
Now that we have a general idea of the kinds of crypto wallets and how they work let’s look at a few real-life examples. In the next section, we’ll explore examples of crypto wallets that are both online and offline, custodial and non-custodial.
Examples of Cold Wallets
The Ledger Nano is a crypto storage hardware similar to a USB that is completely non-custodial and stores private keys offline. A great option for longer-term holderss, the Ledger Nano must be connected to an internet-enabled computer to complete transactions. Hardware storage devices like the Ledger Nano are a relatively safe way to store private keys as they are nearly impossible to hack. I should also note here the recent controversy over Ledger’s firmware updates. As part of a proposed firmware update to Ledger devices, the company had planned to roll out a back up solution which would store your seed phrase divided up amongst three trusted third parties. However, this solution came under fire from Ledger users as it in theory the trusted third parties could conspire to create the entire seed phrase and control users assets. On top of this it introduced firmware which would allow the private key to leave the device. As you can imagine, this news wasn’t well received by the crypto community and Ledger decided to roll back plans to introduce the firmware.
A paper wallet contains the public and private key pairs to complete a transaction on the blockchain. Paper wallets are non-custodial cold wallets that are completely offline. They are usually generated with a key generator as two strings of characters and two Quick Response (QR) codes, printed on paper. Paper wallets allow users complete control of their wallets and may be one of the more secure ways to store keys. However, the main issue with paper wallets is that they are not water or fire-safe and may be easy to lose or destroy. Paper wallets have become less popular in recent years.
Examples of Warm Wallets
Krayon is an enterprise-grade wallet that’s been rapidly gaining popularity. It's currently used by everyone from teams, DAOs, and startups all the way to large enterprises. Krayon uses Secure Multi-party Computation to protect users private keys and has a range of additional features that make it much more convenient for users such as: support for NFTs; Wallet Connect for dApps; fiat to crypto and crypto to fiat; and best execution services for buying and selling cryptocurrencies. The company is also backed by a number of reputable investors like Blockchain Founders Fund, Saison Capital, GSR and Emurgo (the Cardano Foundation).
Examples of Hot Wallets
One of the most popular crypto wallets, the Coinbase Wallet, allows users to store crypto and NFT assets in one place. The Coinbase Wallet supports hundreds of thousands of tokens and dApps. It allows users to connect easily to decentralized platforms to buy, sell, or trade assets. The Coinbase Wallet is a hot wallet that stores users’ private keys online and gives users complete control over their transactions.
MetaMask is another popular wallet that offers convenience and security. MetaMask encrypts users’ private keys and stores them locally on an internet-connected device like a smartphone or laptop. The keys are only decrypted when necessary for transactions.
Like the MetaMask software, TrustWallet is another hot wallet that works with an internet-connected device like a smartphone or laptop. Users can easily access crypto funds with this wallet and connect to decentralized apps to buy, sell, or trade crypto.
There are hundreds of other crypto wallets to choose from. Crypto traders and long-term investors can utilize any of the wallets listed above or a combination of these wallets to ensure the greatest security and convenience.
Crypto wallets come in many unique forms. Wallets for crypto are so versatile; users can distribute funds across multiple crypto wallets and platforms to ensure multiple levels of security and convenience. Crypto wallets enable traders to initiate and complete transactions instantly. Since blockchain doesn’t have “operating hours” like traditional banks, traders can take advantage of this flexibility anywhere in the world, as long as they have an internet connection.
No matter how you or your business choose to store crypto, it’s important always to act cautiously and beware of any scam attempts. With online theft methods becoming more sophisticated, sometimes even the most experienced traders can become victims.
While each kind of wallet provides some level of security, hackers and attacks still present some level of threat, even if it’s minimal. As technology continues to advance, so too do hacking and theft methods. Users must be alert and always take caution when initiating and finalizing transactions. Investors who choose to secure their own private keys should ensure that the keys are clear and stored in a place that is fire-proof and water-proof. An investor using a custodial wallet where a third party holds the private keys must consider the risks involved.
Overall, wallets for crypto can be an excellent source of holding, trading, buying, and selling cryptocurrencies. Crypto wallets can keep assets safe and secure but often come with the responsibility of keeping private keys safe. As traders become more advanced, they may change the kind of crypto wallet that works for them. Ultimately, the options to store crypto are endless and with any of the options we’ve listed above, traders are sure to start on the right foot.
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