Learn everything you need to know about cryptocurrency wallets
In January 2009 the world saw the first cryptocurrency get born — Bitcoin. Since then a lot has happened and now the market cap of Bitcoin is not even 50% of the total cryptocurrency market cap. As of today, there are currently 7266 different cryptocurrencies listed on one of the biggest cryptocurrency market trackers. The total market cap is just north of $2.3T. That is a lot of value that needs to get stored safely somehow, and there are many different ways to store these assets, both safe and not so safe. In this post, we will teach you about the different ways to store crypto assets and which ways are the most safe for you.
What is a cryptocurrency wallet?
Cryptocurrencies like Bitcoin and Ethereum rely on asymmetric encryption for owners of the assets to be able to store them safely. Asymmetric encryption is an encryption method where you generate two keys — one is private and the other public. A cryptocurrency wallet consists of precisely this, two keys where one is private and the other public. Creating a wallet is not hard and can be done by anyone. No matter if you are online sitting at your desktop computer at home or offline in the deepest jungles of the Amazon. As long as you have a device like your smartphone you can participate in the blockchain space by generating your own wallet.
The private key
L2hRy3mDMAhneria7tD9ccRPHwgxuk4R6yt1gRJthHPfsdfhw9x5This is a Bitcoin private key (Do not use it is now compromised)
The private key of a wallet can be used to spend the assets that you have stored in it. This key is very important to store safely as anyone that gets access to it will be able to transfer funds from the wallet. This is also the only key that you have, if you lose it your funds are gone forever. There is no human, government, or supercomputer that can crack or unlock a cryptocurrency wallet. This is very powerful and with great power, you also have to be responsible right? Being responsible in this case means that you need to take great measures not to lose your private key, and usually, this means backing it up multiple times in different secure locations.
The public key
1N91cybpREZbsRiLCmkk1wWaXTSzm5J45NThis is a Bitcoin public key
The public key of a wallet is what is used by other people to send you funds, it is the address of your wallet, it’s similar to a traditional bank account number. People need to know your bank account number to be able to send you funds and they also need to know your public key to be able to send you cryptocurrencies.
A wallets public and private key actually work together because they are mathematically linked to each other. Anyone can use your public key to encrypt data but only you will be able to decrypt it because you hold the private key. You can think of it like a mailbox that is locked… Anyone can put mail into that mailbox but only the owner can open it because they have the key to it. The same principle is used when funds are transferred on blockchains. The sender first needs to decrypt the asset that he wants to send and that will be done with his private key. Then the sender uses the receiver’s public key to encrypt the crypto asset. Now the receiver is the new owner of that asset because only he can decrypt it with his private key.
What is actually stored in a wallet?
Now that we’ve described what a cryptocurrency wallet actually is you might have already realized that the only thing that needs to be stored safely is the private key. In that case, you are right! But storing the private key has proven to be harder than one might imagine. Many people have lost their assets due to many different reasons. Some of the most common are lack of understanding, neglect and hacks. This takes us to the many different types of wallets that you can use, lets start with software wallets.
As the name suggests, Software wallets are wallets that are entirely made of software. These are computer programs that you download from the internet and run on your computer or your smartphone. The first software wallets were so called “full wallets” but the most common ones today are “light wallets”, we will describe them more in detail later in this post.
Software wallets are prone to different types of hacks, for example imagine if your computer or smartphone that is running the software wallet is infected with a virus that scans for private keys. Well, in that case you will most likely get hacked and your funds stolen. You should avoid using software wallets with any significant amount of value. Only store smaller amounts of cryptocurrencies in these types of wallets.
These wallets are usually found in network nodes and can be operated directly from a command-line interface. These are usually not very user friendly and even though they still exist and are frequently used by hardcore blockchain enthusiasts — your average Joe will not be using one of these wallets. Full wallets require you to download the entire blockchain before you are able to transact with them. This is cumbersome and takes a lot of time and it forces you to use devices with massive disk space to be able to use them.
Light wallets are what most users today actually use. Every wallet you use on a smartphone and most wallets you use on a desktop computer is a light wallet. These wallets do not force you to download any blockchain data before you can start using them. However, behind the scenes there will always be a full node that the light wallet is communicating with. Because of the fact that you are actually trusting a third party network node to forward your transactions correctly to the blockchain light wallets are not as safe as full wallets.
If you hold a significant amount of crypto assets you should definitely consider investing in a hardware wallet. A hardware wallet is a separate piece of hardware device that stores your private key in a secure way. They come in different variants, some are completely air-gapped and offline whereas others will allow you to connect to them through different interfaces such as Bluetooth or a USB connection. The most important thing is that they will all protect you from computer viruses trying to steal your funds. Even if you connect a hardware wallet to an infected device your funds will remain safe because the private key is stored in a secure chip in the hardware wallet and the private key never leaves the device. The only thing that leaves the device (if it’s not completely offline) are signed transactions. So what is a signed transaction then? Whenever you send a transaction on a blockchain you will sign this transaction with your private key. In a traditional software wallet this signing happens on your computer or smartphone. However, when using a hardware wallet this signing process is done on the hardware device. Thanks to this your private key never has to leave the device.
A custodial wallet is a wallet that you have access to through a custodial service. The most common custodial wallet services are provided by centralized exchanges such as Coinbase, Kraken, and Bitstamp. These services will store your private key for you. This could be more or less safe depending on if the 3rd party service is trustworthy and what measures they take to make sure your keys are safely stored.
Unfortunately, history has repeatedly shown us that storing crypto assets on custodial services on a long-term basis is a very bad idea. The first time people lost a massive amount of Bitcoin due to a custodial service mismanaging their customer’s assets was the famous Mt. Gox exchange.
Back in the early days of Bitcoin (2011-2014), Mt. Gox was the leading Bitcoin exchange and it was handling roughly 70% of all Bitcoin trading. Mt. Gox lost more than 750,000 of their customer’s Bitcoin. A while later Mt. Gox found roughly 200,000 of these Bitcoin in an old wallet they had kept stored somewhere. Still today though, the majority of Mt. Gox’s customers that were affected by this mismanagement of assets have not received their Bitcoin back.
After the Mt. Gox incident there have been an endless amount of cases with similar results. Even though these kind of incidents were more common a couple of years back they are still a possibility today and users should be very careful of trusting any third party with their crypto-assets.
Every crytocurrency user should keep in mind and remember one thing: Not your keys, not your crypto
Non-custodial wallets are all wallet types where you and only you have access and control of the private key. This includes software wallets and hardware wallets. A wallet service where a trusted 3rd party has control of your private key is never a non-custodial wallet service.
A cold wallet is any wallet that is completely offline. This could be both software wallets and hardware wallets. The important thing here is that the wallet is completely offline and that it has never had access to the internet. Cold wallets are only considered cold for as long as they’re offline.
Hardware wallets are usually considered cold wallets, as they never connect to the internet. Software wallets that are installed on devices without internet access are also considered cold wallets. As soon as a cold wallet goes online and connects to the internet it becomes a hot wallet.
Cold wallets are considered safe, they are much safer than hot wallets that we will be discussing further down in this post.
Receiving cryptocurrency to a cold wallet
It doesn’t matter if a wallet is offline, online, hot or cold. Funds can still be sent to it because remember, the wallet is actually just a private key that is linked to a public key that users can send funds to. All of the transacting and book-keeping happens on the public blockchain that is constantly online.
Sending cryptocurrency from a cold wallet
It’s also possible to send funds from a cold wallet, even though it’s offline. Actually this is not entirely true because cold wallets are offline they have no way to interact with nodes and broadcast a transaction. But! Cold wallets can create a transaction locally and offline and then sign it. You can then copy this signed transaction over to an online device and broadcast it to the blockchain from there successfully.
Contrary to cold wallets that are always offline a hot wallet can be both offline and online. However, unlike cold wallets that can become hot wallets, a hot wallet can never become cold. Even if the hot wallet goes offline it is still considered hot. This is a safety precaution because as soon as you connect to the internet you are exposed to the potential risk of getting infected with a virus or someone eavesdropping on what you do and what your private key is. Because of these risks hot wallets are much less safe than cold wallets and you should never store any significant amount of value in hot wallets.
There are many different ways to store your cryptocurrencies. Some are good and some are bad. What it comes down to in the end is risk management and how well you manage that risk. For the vast majority of people out there that hold more than a couple 100 dollars worth of cryptocurrency a hardware wallet is very much recommended. Hardware wallets are cheap and they all serve the same purpose — to keep your private key safe. If you don’t already have a hardware wallet you should definitely check out our list of hardware devices over here and consider investing in one buy purchasing from one of the vendors.