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How Does a Cryptocurrency Wallet Actually Work?

July 13, 2020
5 min
How Does a Cryptocurrency Wallet Actually Work?
Beginner
You will learn

    Introduction

    To start buying, selling or trading Bitcoin or any other cryptocurrency, you need to have a wallet. 

    Cryptocurrency Custody

    The crypto wallet is the tool that gives access to your cryptocurrency. Unlike the traditional wallet that we carry in our pockets or in a bank account, this one does not physically contain our cryptocurrency. These are actually on the blockchain.  

    On the wallet are recorded the private key, the public key, the public address, the transaction history and the balance of the cryptocurrency you have.  The key element of the entire cryptocurrency custody system is the private key. The private key generates the public key, which then generates a public address. 

    The public address, as the name suggests, can be shared with everyone. If, for example, a friend wants to send us bitcoins, we will give him or her the public address of our wallet which, for this purpose, works like a bank iban. 

    The private key, however, is to be kept carefully. Only with the private key, in fact, you can authorize transactions from your own wallet to someone else’s, and provide cryptographic evidence of where your bitcoins come from.

    A Transfer of Ownership

    We said that the wallet does not physically contain the cryptocurrency, but that these are on the blockchain that you can access with your private key. So how does a cryptocurrency transfer work, then?

    Let’s take as an example sending a bitcoin to our friend Mark. When we authorize a 1 bitcoin transaction from our wallet, all we do is sign the ownership of that bitcoin to Mark’s wallet address. In other words, when we send 1 bitcoin to Mark’s wallet, the blockchain records permanently and immutably that that bitcoin is now his property. 

    Memo

    It’s not bitcoins that move, it’s the owner that changes. The wallet is your small corner of blockchain that only you can access and that shows the percentage of cryptocurrency you own.

    Wallets can be defined as “hot” and “cold” depending on how they operate. It is called hot because it is connected to the internet, while “cold” wallets are offline most of the time. 

    The Hot Wallet: Ready-to-Use

    They are online wallets, on average less secure, but allow you to use your cryptocurrency conveniently and quickly, offering more services than cold wallets.  They can be apps, desktop software, websites, or exchange wallets.

    They are ideal for those who want to start a journey in the world of cryptocurrency, because they are easier to use and help you understand the mechanics of the market gradually, without the risks involved in managing your own investments. 

    Moreover, being connected to the Internet and therefore to the blockchain, they allow you to buy and sell cryptocurrency in just a few minutes. In times of great market volatility, i.e. when prices rise and fall very quickly, it is essential for an investor to be able to operate immediately, both to contain any losses and to obtain the desired profit margin. 

    It should be kept in mind that hot wallets are more vulnerable than cold wallets to hacker attacks and phishing attempts, precisely because they are connected to the Internet. 

    The issue of account security is central to any company offering cryptocurrency custody services, such as an exchange. So, even when the procedures for accessing your funds will seem a bit cumbersome and with several steps to take, they are actually meant to protect your cryptocurrency.

    The Cold Wallet: Your Safe

    They are offline wallets, so they are safer, ideal for keeping large and long-term investments. There are several solutions, each with unique properties.

    These can also be apps or desktop programs, but they are not connected to the internet. This does not make them completely immune, since even a computer or smartphone can be affected by viruses or hacked. The most secure cold wallet of all is the hardware (USB flash drive) or paper wallet. The paper wallet, however, does not allow the direct use of cryptocurrencies, as it only keeps the private key.

    Like a safe, they keep most of your cryptocurrency very safe at the expense of ease and immediacy of use.

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