We know or at least have heard that cryptocurrencies are stored in wallets. Let’s take a closer look at what crypto wallets are and how they work.
Crypto wallets hold the user's public and private keys, offering a user-friendly dashboard to oversee their cryptocurrency amounts. These wallets facilitate movements of cryptocurrency via the blockchain. Several wallets give users the capacity to conduct particular tasks with their cryptocurrency, including trading or engaging with decentralized apps (Dapps).
It's essential to grasp that cryptocurrency transactions aren't about 'transmitting' cryptocurrency units directly from one person's device to another. The crypto currencies aren’t “moving” anywhere per se. In such transactions, the user's private key authenticates and relays it to the blockchain system. This system then records the action, displaying updated values for both the initiating and receiving parties.
Although we use the term 'wallet', it's not entirely accurate. Unlike traditional wallets that physically store money, cryptocurrency wallets interact with the public ledger to display an individual's balances and secure the private keys necessary for transactions. So basically, the wallet is like a location address and the blockchain system has a record of all the transactions that have occurred in and out of that address, so your wallet’s interface or dashboard is basically summing up all the transactions that have happened and displaying the final result as of that moment.
Curious about Public and Private Keys?
Consider a key as a unique sequence of unpredictable symbols. Your public key can be likened to a bank account number, safe to be widely distributed, while your private key resembles a bank's account PIN or password, meant to remain confidential. It should be noted that unlike bank account PIN or password, the private key can’t be “reset” by anyone. If you lose it, you will never be able to access the crypto currencies in that wallet again. And if someone else knows your private key, that person can take every last bit of crypto funds and send it to any other wallet. If you know the private key, you are the owner of the wallet and the associated crypto currencies. Therefore, in crypto, there is the concept of “self custody” because only the one who knows the private key can access and control the crypto currencies of that associated wallet. One public address is associated with one private key.
Are there different types of wallets?
Yes, while we could get into the specifics of the technologies underlying the wallets, for now, let’s look at wallets in two big buckets: hot wallets and cold wallets.
Hot Wallets
The primary distinction between hot and cold wallets hinges on their internet connectivity. Hot wallets have online access, whereas cold wallets remain disconnected. Therefore, hot wallets are in the form of either web, mobile, or desktop software apps. Consequently, assets in hot wallets can be more readily approached, rendering them more susceptible to unauthorized breaches. At the same time, it is more convenient and more readily available to transact using your crypto currencies.
Within hot wallets, private keys reside encrypted on the respective online application. Utilizing a hot wallet introduces risks because of latent cyber vulnerabilities susceptible to intrusions from cybercriminals or harmful software. Storing substantial cryptocurrency quantities in a hot wallet isn't a sound security approach. Nonetheless, potential risks can be lessened with enhanced encryption hot wallets or gadgets that confine private keys in a fortified compartment.
There's an array of motivations for investors to either keep their cryptocurrency online or offline. Therefore, it's frequent for individuals to maintain diverse wallets, amalgamating both hot and cold types.
Cold Wallets
As previously touched upon, a cold wallet operates without internet connectivity. Though lacking the immediacy of hot wallets, cold wallets champion superior protection. Tangible mediums for cold storage could be a document or etched metal.
Cold wallets would entail some sort of hardware, like a discrete peripheral, predominantly USB or Bluetooth oriented, preserving a user's keys. Transaction endorsement necessitates pressing an actual button on this tool, keeping it beyond the grasp of digital malefactors. Basically, you need it to be in your hands to transact.
The optimal method to preserve cryptocurrency resources that aren't immediately needed is within a cold wallet. Still, individuals must comprehend the onus of safeguarding their assets rests solely on them — it's their duty to guard against loss or theft.
Advice: To amplify protection, segregate public and private keys, maintain their offline status, and position the tangible wallet in a protected vault.
Although, originally we looked at wallets in two buckets, another major categorization can be custodial vs. non-custodial wallets. This is more of a concept of ownership and control.
Custodial wallets are more akin to traditional bank accounts in that they are wallets that are controlled not solely by you but on your behalf by a trusted (hopefully) third-party. This means that the third-party provider will be using either a cold or hot wallet (or a combination of both) to custody your assets, which also means that they control and own the private keys that your assets are in. However, the advantage is that for beginners who are not used to the concept of private keys and safeguarding them on their own, they can have more ease of use and convenience.
Non-custodial (also called self-custody) wallets are the ones that the user controls completely because they are the only ones who were given access to the private keys upon creation.
When creating a non-custodial wallet, users are prompted to note and securely store a sequence of 12 arbitrary words, termed a 'recovery', 'seed', or 'mnemonic' phrase. This set of words allows for the creation of the user's public and private keys, serving as a safety net should they misplace their device.
Gaining possession of this seed phrase means having complete authority over the wallet's contents. If a user misplaces this phrase, they also forfeit access to their assets. Hence, it's crucial to safely store the mnemonic phrase and avoid making any digital record of it.
In conclusion, there are hot wallets and cold wallets, which hinge on whether or not they are connected to the internet. And with respect to ownership and control, a wallet can be custodial or non-custodial. No type of wallet or custody is going to always be better - these will be user and situation specific.