I've had many conversations with friends about crypto and NFT's. It usually comes down to learning that they have their cryptocurrency on a platform like Binance, Coinbase or Robinhood. All I can say to them at that point is, "not your keys, not your crypto", with not a very clear backing.
So, I decided to give a more technical answer and understand how cryptocurrency wallets work. Hence, this post.
In this post, we will go over cryptocurrency wallets from a technical point of view. If you are new to the crypto space, please be sure to continue reading. It's really not your crypto unless you have your own keys, and I'll try to explain why. 👀
What is a cryptocurrency wallet?
A cryptocurrency wallet -a crypto wallet for short-is like a regular bank account for your digital assets. It allows you to send and receive cryptocurrency transactions.
The wallet doesn't actually hold your cryptocurrency. Instead, wallet addresses are added to the ledger as part of the transaction details. From there, you can derive the amounts in each wallet address.
Cryptocurrencies are not at a physical location. A wallet is not a block on the blockchain that has your funds. Rather, cryptocurrencies are digital, and a crypto wallet signs the transactions—the blockchain records who is signing the transactions.
In short, a crypto wallet is what allows you to talk to the blockchain network. It gives you the tools you need to interact with cryptocurrencies. Examples of cryptocurrency wallets are Metamask, Ledger, Phantom and TrustWallet.
How does it work?
A crypto wallet generates a private key and a public key. The main functionality of a crypto wallet is to store these keys and sign transactions.
A single wallet can have more than one public key and/or private key. Basically, the public key(s) is derived from the private key.
To understand the functions of these keys, we need to understand cryptography. Let me try and explain how it works below.
Public key
A public key is, as the name indicates, public. This is like a Twitter handle. Anyone who knows your Twitter handle can see your profile and send you a message. Likewise, anyone that knows your public key can send you funds.
Like your bank account number. (Unique BTC address, ETH addresses are generated from public keys.).
If you give your public address or associated crypto addresses, then people can send you cryptocurrencies. The cryptocurrency doesn't leave the blockchain, it's transferred from one account to another. Basically, a new entry on the ledger says that a certain amount of cryptocurrency moved from account-X to account-Y.
Private key
A private key is like your password. You should keep it safe and never share it with anyone. Anyone with your private key has full access to your wallet.
The private key allows you to make transactions and access your funds. For example, you can spend cryptocurrencies with your private key. It's like your bank account password.
Let's say you want to send some Bitcoin. In this case, you need to sign the transaction with your private key. After approving the transaction-which means proving you are the owner of the wallet-you will see that there is a new transaction transferring your Bitcoin. It's a new entry on the ledger.
The private key is the most important key of a wallet because the public key and the crypto addresses are calculated from it. So you can recover the other addresses by using your private key.
Most modern wallets use a "seed phrase" to generate a private key. The seed phrase is a 12 to 24-word combination. With the seed phrase, users can generate private keys. If you have multiple private keys, you can generate them by the seed phrase and don't need to remember each private key. In other words, the seed phrase gives access to all keys in the wallet.
Types of Cryptocurrency Wallets
Let's go over custodial vs non-custodial wallets and then hot vs cold wallets.
Custodial Wallets vs Non-Custodial Wallets
Users or third parties can own private keys; that's what makes a wallet custodial or not.
Custodial Wallets
A third-party (generally an exchange such as Coinbase, Binance, Robinhood) has your private keys and signs transactions on your behalf. You trust the third party to hold the keys for you. This has both advantages and disadvantages.
The advantages are that custodial wallets are easy to use as you can go to the exchange's for your country, sign up and start buying/selling. Users can also benefit from lower transaction fees, recovering their account if they lose their password etc. Features vary depending on the third party.
However, you don't have any control over your keys; you trust the third party. So it's the third-party that owns your keys.If there are any issues with the third party, such as a cybersecurity attack or regulatory issue, you can lose your crypto.
Since users have dominantly used centralized exchanges, they have been a significant target for cyber-attacks. Here are some, to name a few: KuCoin, Altsbit and Liquid.
Non-Custodial Wallets
The user owns the private keys of the non-custodial wallet. Unlike a custodial wallet, there is no third party in between. Therefore, the user is the only person that has the private key and/or seed phrase.
Non-custodial wallets fit more into the decentralized world. No other person or third-party can have access to your private key and thus can not make any transactions from your wallet.
However, it's important to understand the responsibilities and risks associated with it. Users are fully responsible for the security and the backup of the wallet. For example, there is no customer service can help out if the user loses their private key.
Both custodial and non-custodial wallets have their advantages and disadvantages. It is essential to understand how they work and their responsibilities to decide which to choose. I choose the latter and take my precautions.
I am not a financial advisor, make sure to do your research and come to a decision. 😀
Hot Wallets vs Cold Wallets
Hot and cold wallets differ according to where the keys are stored.
Generally, hot and cold wallets are non-custodial wallets. That been said, be sure to check the wallet you are using to understand how the keys are managed.
Hot Wallets
A hot wallet is a software-based wallet. The wallet is connected to the internet at all times.
The advantage of a hot wallet is that it’s easy to use because you can manage all your assets directly from the software without needing another tool or device.
However, since the keys of a hot wallet are stored on the internet, as you can imagine, there are many hacks made on these kinds of wallets. There are fake software wallets that aim to get your seed phrase, even fake customer representatives getting your seed phrase. Your computer can be infected with malware/spyware, getting your private information to access your funds. These are some of the standard methods used by hackers.
Metamask is a popular browser-based wallet on the Ethereum network.
Cold Wallets
In a cold wallet, the keys are not on the internet. Instead, the private keys are stored on the hardware device. It’s usually a USB like device which you need to make transactions.
All the transactions require a physical device; thus, it's an extra layer of security compared to a hot wallet. Again it's crucial to keep your seed phrase to yourself and not store it online.
There are, of course, hackers targeting these hardware wallets too. Fake hardware devices and fake customer service representatives are some of the most popular hack types, to name a few.
Ledger and Trezor are two popular hardware wallets.
Overall, choosing between a hot or a cold wallet seems like a tradeoff between ease of use and security. Security seems like the winner between the two. 😉
The crypto space is new and experimental. In this setting, it's essential to understand the different options for crypto-wallets. Especially with the number of responsibilities users have in the crypto world, be sure to spend the appropriate time choosing the best wallet for your use case.
I hope that this article was helpful. If you have any questions or comments, feel free to drop them below or reach out to me from Twitter!