What is a crypto wallet and how does it work?
November 22, 2022
Crypto wallets provide the tools to send, receive and store tokens and coins. They are essential for anyone who wants to participate in the blockchain ecosystem. There are different types and for various purposes: let’s discover all the ways to store cryptocurrencies.
What is a crypto wallet?
A crypto wallet is a necessary tool for managing your cryptocurrencies. It keeps track of exchanges and shows user’s balances, which is why it is commonly referred to as a ‘digital wallet’. However, it does not physically contain the tokens, because they are actually stored on the blockchain: the shared ledger that records information on all crypto transactions. Each wallet corresponds to a blockchain address that indicates where your crypto data is stored.
However, a crypto wallet is mainly used for making payments on the blockchain, by exploiting cryptography. To make a payment in cryptocurrencies, three cryptographic codes are needed: a private key, a public key and the aforementioned address, which is generated when a wallet is created and automatically associated with it. Specifically, the address and public key allow you to receive tokens, while the private key allows you to send and then use them.
So what is a crypto wallet in practice? It is a computer programme or device that simplifies the management of these cryptographic keys. But how does it actually work?
How a crypto wallet works: public and private keys
Crypto wallet cryptography is based on two fundamental codes, the public key and the private key. These two keys take the form of a series of letters and numbers. Understanding their role helps us understand how a crypto wallet works on a technical level.
In a nutshell, the private key has the same function as a password: only those who know the correct combination can ‘open’ the corresponding wallet, so that they can make use of the funds inside. This is why it is essential to keep it secret, and never to lose or forget it.
The public key, on the other hand, can be communicated and shared to receive crypto. However, the address, which is a code derived directly from the public key, is often used for this purpose.
You can see for yourself how cryptocurrency exchanges work by consulting a blockchain explorer. Since blockchains are generally transparent and public, by searching for an address, you can view all transactions made by the corresponding wallet.
Now that you understand what a crypto wallet is, before creating one, you will need to choose the type that best suits your needs. In fact, there are several categories of cryptocurrency wallets. They can be distinguished according to the following aspects:
- The delegation of public and private keys: a custodial wallet is a service provided by a third party that holds your keys for you. Using a non-custodial solution, on the other hand, you take care of them yourself;
- Online or offline: respectively hot or cold wallets;
- The device or programme you want to use: hardware, software or paper wallet.
Let’s describe the various types of crypto wallets, listing their advantages and disadvantages, so you can discover their features and differences. Finally, you will be able to find the most suitable solution for you.
Non custodial wallet
A non-custodial wallet gives complete control of the funds to the owner, because private keys are kept without involving third parties. This type of wallet is more accurately called self-custodial: the user needs to remember their own private keys, i.e. the ‘passwords’ to access his crypto funds.
In reality, the creation of a non-custodial wallet consists first of all in the generation of a seed phrase (or recovery phrase), the only ‘formula’ that you really need to memorise. A series of 12 or 24 words, from which an algorithm derives the private key associated with the wallet itself. The seed phrase proves ownership of the funds: anyone who knows it will be able to access or recover the corresponding wallet, which is why it is important that it remains secret and hidden in a secure location, preferably offline. Discover other measures to maximise the security of your accounts and wallets in the password management guide.
Each wallet has a single seed phrase, but it can also collect multiple addresses and store multiple keys, if compatible with different cryptocurrencies.
Therefore, a non-custodial solution grants the owner exclusive access to the funds, an advantage that may also turn into a risk. If the user loses the self-stored seed phrase, no support service can help them recover it. Moreover, self-custodial wallets are usually more difficult to use than, for instance, the user-friendly interfaces of an exchange wallet.
The owner of a non-custodial must protect themselves from social engineering strategies. Fraudulent activities such as phishing are employed by hackers to steal private keys and seed phrases. This is why many users prefer to manage their cryptocurrencies through custodial wallets, solutions that outsource the storage of keys to third parties.
These wallets are also called “hosted” because they are hosted by exchanges or other online platforms. They repay the user’s trust by guaranteeing the security of funds. First of all, custodial solution companies provide KYC (Know Your Customer) services. They verify the user’s identity to prevent illegal activities such as money laundering (AML). The person is required to set a password to access the funds, making it unnecessary to remember seed phrases and private keys.
Finally, other security measures, such as two-factor authentication (2FA) or biometric recognition, can be employed to protect your crypto. However, this is not enough for those who utter the motto ‘not your keys, not your coins’. If you delegate custody of your keys, you relinquish the sole control of your cryptocurrencies. For many, trusting an exchange is an advantage: it eliminates the risk of forgetting the seed phrase and simplifies the management of tokens and coins.
Hot wallet vs. cold wallet
The internet connection of your wallet is a determining factor in the security of your cryptocurrencies. At this point, it is worth exploring how a hot crypto wallet works compared to a cold one, and what are the differences between the two types.
Hot wallets are online software, thus allowing crypto transactions to be executed quickly, if not immediately, and are also easy to use. Cold wallets, on the other hand, are physical, offline devices that are more complex to use. Transferring cryptocurrencies from an offline wallet requires several steps. It must first be approved by the device that holds the keys, and then go through a hot wallet that transmits the transaction to the network. Indirect internet access slows down cold solutions, but has one advantage: it makes them more secure, because they are not exposed to hacks, which can be widespread online.
If you trade cryptocurrencies on a daily basis, perhaps a hot wallet is more convenient. However, if you plan to employ a holding strategy, cold wallets are functional for storing cryptocurrencies for the long term, as they are immobilised offline.
Software, Hardware and Paper Wallets
There are 3 other types of cryptocurrency wallets: software, hardware and paper, depending on the ‘medium‘ in which the private keys are stored.
Essentially, a software wallet can be a programme for smartphones (mobile wallet), computers (desktop wallet) or a browser extension (web wallet). All these solutions are constantly connected to the internet (hence the term ‘hot’), so that exchanges are almost instantaneous. On the custody side, on the other hand, we find:
- custodial wallets such as exchange wallets, a particular type of web wallet integrated into crypto trading platforms such as Young Platform;
- non-custodial wallets such as Metamask, either in mobile form or web extension form, or any type of desktop wallet.
On the other hand, hardware wallets are physical devices similar to USB sticks that store private keys offline. Trezor and Ledger are the main providers of these types of cold solutions that, in order to transmit transactions to the blockchain network, still need software installed in the device itself.
Finally, paper wallets are simple sheets of paper bearing private keys and blockchain addresses, sometimes printed as QR codes. This solution is now in disuse, mainly due to the risk of loss and the impossibility of reusing them after the first outgoing transaction; however, it characterised Bitcoin exchanges at the dawn of the cryptocurrency world.
To choose the most suitable one for your needs, it is not enough to know what a crypto wallet is and how it works: check out the article Wallet: the best solution for you to learn about all these storage options in detail.