Wallets explained
A common misconception is that a wallet holds your cryptocurrencies and other crypto assets, similar to cash in a regular wallet. Your coins, tokens and other crypto assets are stored on the blockchain. A wallet holds the cryptographic keys that allow you to interact with your account on the blockchain and so control your assets. It’s not like you could just take a bitcoin out of your wallet and store it locally on your computer. A blockchain is essentially a very large and complex database storing data. A bitcoin, for example, is in fact nothing more than data registered in this database. Through the keys stored in your wallet, you can interact with the blockchain and send or receive that bitcoin, but everything takes place on the blockchain. The wallet is merrily your gateway to it. [2]
Cryptographic keys
Let’s look at the stuff in your wallet in more detail.
Private Key
First and formoste, there is the private key. As mentioned before, your private key is not stored on the blockchain. It is solely stored in your wallet. The private key allows you to sign transactions and so control the crypto assets that you own. The private key signature is always necessary to send crypto. It proofs that you’re indeed the person who owns the crypto-assets before a transaction is processed. [3]
Private key is like the pin code that you need to authorize transactions from your bank account. Similar to your pin code, never share it with somebody else!
Public Key & Address
Beside the private key, you also have a public key. It is your unique identifier on a blockchain and is cryptographically derived from your private key. The public key is often referred to as your wallet address. However, this is not correct. Your public is indeed the unique identifier (similar to an address), but it’s not the address that you share with others so they can send you crypto assets. On the Bitcoin blockchain, your wallet address is created by “hashing” (encrypting) your public key. [4] On the Ethereum blockchain, your address comprises of the last characters of your public key. [5] Other blockchains might have even different approaches, but make sure to keep in mind that the public key and the address are not 1 on 1. There’s is no harm in sharing your public key or address for that matter. To illustrate, this is an address that belongs to Vitalik Buterin, the co-founder of the Ethereum blockchain: 0xd8da6bf26964af9d7eed9e03e53415d37aa96045. [6]
You can think of your public key as the unique number the bank uses to identify your bank account and your address as the account number (IBAN in the EU) that other people can send money to.
This may sound quite complex, but wallets these days are almost fully automated and very user-friendly. Sending cryptocurrencies involves entering the receiving address and approving the transactions with a click of a button. By approving the transaction you’re in fact using your private keys to provide the digital signature as explained above.
Usage
Wallets play a vital role within the crypto industry and have a variety of uses. Here’s an overview of what a modern crypto wallet can do. [7]
- Control your private keys and keep them safe and secure;
- Manage the digital assets in your account;
- Send and receive crypto-assets to and from addresses on the same blockchain;
- Bridge crypto assets from one blockchain to another (“send” cryptocurrencies from Blockchain A to Blockchain B);
- Interact with dApps (decentralized applications);
- Make purchases at (web)shops that accept cryptocurrencies.
Furthermore, as you may have already derived from the fact that we keep referring to crypto assets and not just cryptocurrencies, a wallet doesn’t just give you access to your cryptocurrencies. Your wallet allows you to control all crypto assets that you own, including, for example, NFTs.
Multiple blockchains
An account is on one blockchain and that blockchain alone. Since the crypto industry is growing rapidly and you have many different blockchains to choose from, you may want to have accounts on multiple blockchains. Modern wallets are mostly designed to facilitate access to accounts to multiple blockchains, all from the same application. You can add multiple networks (blockchains) to your wallet allowing you to interact with each one. It depends on the wallet that you’re using if you have to create an account on the new blockchain first or if it is done automatically. Make sure to check this thoroughly before bridging or sending any assets. Sending assets to a non-existent address will result in the permanent loss of your assets. [8]
Furthermore, you should always keep in mind that your digital assets live on the blockchain and not in your wallet. Meaning that adding a new blockchain to your wallet only grants you access to that blockchain and doesn’t change anything else. If you want to send your crypto assets to the new chain, you to bridge your crypto assets to your new account first Never send crypto assets on Blockchain A to a new account on Blockchain B. Doing this will result in the permanent loss of your assets. [9]
Sending crypto assets from to a different blockchain is not possible and will result in the permanent loss of your assets. Always use a blockchain bridge!
Types of wallets
There are many different types of crypto wallets and each has its own characteristics.
Custodial wallets vs Non-custodial wallets
When talking about custodial vs non-custodial wallets, people are not talking about who owns the crypto assets, but about who controls the private key. In other words, who has custody over the private key? The private key of a custodial wallet is in the custody of (controlled by) a third party. So, when you issue a transaction from a custodial wallet, this third party has to sign the transaction with the private key instead of you doing it yourself. [10] Custodial wallets are usually offered as a service by centralized exchanges to make it easier to manage and trade crypto assets and to make it easier to recover lost passwords. Examples of custodial wallet providers are centralized exchanges such as Coinbase [11].
Especially since the demise of the centralized exchange FTX, the phrase “Not your keys. Not your coins.” has become popular within the crypto community. This phrase refers to the fact that if you don’t hold your private keys, you are not in control of your crypto assets and thus you don’t actually own them. [12] Also, exchanges may not provide a personal custodian wallets and pool all assets together. [15]
Non-custodial wallets do not have any third party with custody of the private key. You, as the owner of the wallet, are the sole owner i.e. custodian of the private key(s) in the wallet. This allows direct control of all crypto assets in the associated accounts without any third party. [13] An example of a popular non-custodial wallet is a wallet like Metamask. [14]
Since your account is ON-CHAIN, even if the provider of the non-custodial wallet goes out of business or you just want to switch to another wallet, you can transfer your wallet’s keys to another compatible wallet and regain control over your accounts. [15]
Software vs hardware wallets
A software wallet is a wallet application that runs on a mobile phone, browser or another non-dedicated device. Software wallets are very common and allow you to interact with a blockchain using an app on your phone or browser, for example. Software wallets are usually “hot” since they are (in most cases) always connected to the internet.
A hardware wallet is a dedicated device that functions as a wallet (holds your private keys). They usually come in the form of a thumb drive. Since the private keys are separately stored on this device, you first need to connect it to the internet before interacting with a blockchain. Hardware wallets can be “cold”, but they don’t have to be. Some hardware wallets, when connected to the internet, can expose your private keys to a connected application or DeFi protocol. However, most hardware wallets store your private key permanently offline, even when you interact with a blockchain. [16]
Paper wallets
There is one other type of wallet remaining. It’s the so-called “paper wallet”. Especially in the early days of Bitcoin, users of the Bitcoin Blockchain had to write down their private keys on a piece of paper. Every time they wanted to send bitcoin, they had to use software capable of interacting with the Bitcoin blockchain and enter their private keys by hand. [17]
Wallet security
Security is a big deal within the crypto industry. Scammers are active in abundance and mistakes are usually irreversible. Hence, it’s safe to say that you need to be aware of certain wallet security aspects.
Seed phrase
A seed phrase is a cluster of random words that are generated when you first set up your wallet. Seed phrases are often referred to as recovery keys. When you lose access to your wallet and you need to restore it, your wallet application will ask you to enter your seed phrase. When you enter it correctly, your wallet will be restored and you will have access to your crypto assets once again. [18] However, if you’re unable to reproduce your seed phrase correctly, your wallet cannot be restored and you will permanently lose access to your assets permanently. In other words, make sure to write down your seed phrase, perhaps even multiple times, and store it in (a) save place(s). What’s important to know is that anybody who has your seed phrase can create a copy of your wallet. The only thing they have to do is enter it into a compatible wallet application. After, they will have full control of the crypto assets of all your accounts. In other words, make sure to keep your seed phrase not only safe but private as well.
Your seed phrase is the only thing that you can use to restore your wallet. Keep it safe and keep it private at all times!
Hot vs cold storage
In the above, we explained the difference between software and hardware wallets and touched upon hot versus cold storage. With regards to safety, there’s an important difference between the two you should be aware of. Hot storage means that your wallet is always connected to the internet and is ready to sign transactions. This is very handy if you’re making a lot of transactions. However, there is a big safety concern. Since your wallet is always connected, hackers can gain control of your wallet by infecting the device or application that is running the wallet with malware. If they manage to do so, they can steal all your crypto assets.
When you store your assets in so-called cold storage, it’s harder for criminals to gain access to your funds. A wallet that is “cold” is not ready to sign and first needs to be connected to the internet. In other words, when a scammer wants to steal your assets in cold storage, they need to physically obtain your cold storage device and connect it to the internet first, before they can transfer your crypto assets. Hence cold storage provides a far greater level of security compared to hot storage. [19]
Custodial vs non-custodial
Another safety aspect to take into account is the choice between custodial and non-custodial wallets. As explained above, a custodial wallet, or better said, a custodial wallet provider, holds custody of the private keys. This means that the wallet provider in fact has control of your assets. A good illustration would be the example where you hold your cryptocurrencies with an exchange. You can simply log in to your exchange and send cryptocurrencies by telling the exchange to do so. The difference with a non-custodial wallet is that the non-custodial wallet holds private keys. Hence you have complete control over your assets. There is no middleman.
The safety aspects in this regard are as follows. If you opt for a custodial wallet, you will enjoy a greater level of comfort. For example, if you forget your password, you can call the wallet provider’s customer services and have it reset. In contrast, if you opt for a non-custodial wallet and cannot access it anymore and save your seed phrase you will permanently lose access to your account and thus your crypt assets. However, when you opt for a non-custodial wallet, you’re in complete control and you don’t have to worry about a middleman making mistakes or being untrustworthy. For example, when an exchange defaults (goes bankrupt) you most likely lose all or at least part of the assets that this exchange was holding for you. [20]
SOURCES
- Ethereum Foundation: Wallets
- Mastering Bitcoin: Chapter 1. Introduction | Author: Andreas M. Antonopoulos
- Mastering Bitcoin: Chapter 4. Keys, Addresses, Wallets | Author: Andreas M. Antonopoulos
- Idem.
- Etherscan: 0xd8dA6BF26964aF9D7eEd9e03E53415D37aA96045
- Mastering Bitcoin: Chapter 4. Keys, Addresses, Wallets | Author: Andreas M. Antonopoulos
- Coinbase: What is a crypto wallet?
- Coinbase Help: I sent funds to the wrong address. How do I get them back?
- 10Clouds: How to Transfer Ethereum to Other Blockchains
- Coindesk: Custodial Wallets vs. Non-Custodial Crypto Wallets | Author: Jackson Wood
- Coinbase Help: What’s the difference between Coinbase.com and Coinbase Wallet?
- Ledger Academy: Not Your Keys, Not Your Coins. It’s That Simple | Author: Kirsty Moreland
- Kraken Support: Differences between a crypto exchange and a crypto wallet service
- Coindesk: Custodial Wallets vs. Non-Custodial Crypto Wallets | Author: Jackson Wood
- Metamask Wallet
- Ledger Academy: Hardware Wallets and Cold Wallets: What’s the Difference? | Author: Kirsty Moreland
- Trust Wallet Blog | How to Import Your MetaMask Wallet into Trust Wallet | Author: Alex Lilacher
- Mastering Bitcoin: Chapter 4. Keys, Addresses, Wallets | Author: Andreas M. Antonopoulos
- Idem.
- Ledger Academy: Hardware Wallets and Cold Wallets: What’s the Difference? | Author: Kirsty Moreland
- Fortune Crypto: With FTX on the verge of collapse, customers are wondering what happens to their crypto. Here’s what to do if you have an account there | Author: Megan Leonhardt