Cryptocurrency Wallet – How Does It Work?

TL;DR

Wallets store information needed to receive coins and validate your transactions.

There are different types of wallets available based on their accessibility.

What is a wallet?

(If you wish to understand what bitcoin is before reading this article please click here)

Bitcoin and other cryptocurrencies are digital currencies.

So unlike popular belief, your wallet doesn’t hold any of your cryptocurrency as there is no physical form like bills.

The transaction details are stored on the blockchain.

And the wallets are a gateway to access the blockchain.

Wallet stores the keys needed to prove that you own the currency and you want to use it.

Why is a wallet needed?

You must have come across this famous saying.

NOT YOUR KEYS NOT YOUR CRYPTO

When you keep your coins at the exchange (like Coinbase and others) you leave custody with the exchanges.

While the exchanges take considerable steps to keep your coins safe, there are few risks also.

You might lose your coins if the exchanges are hacked or they mismanage your coins.

One of such incidents was the hacking of Mt. Gox in 2014. Around 850,000 bitcoin were stolen from the exchange.

How does a wallet work?

Wallets have 2 keys – Public keys and Private keys.

Public keys needed to receive cryptocurrencies
Private keys needed to verify the ownership of your coins

The public key identifies your account in the network. Think of it as a bank account number. When someone wants to send you cryptocurrency, they will send it to your account.

The private key is like the password of the account. It proves that you own the related public key. The private key lets you transfer, withdraw or spend your coins.

The public key and the private key are mathematically linked with each other.

How the keys look like:

Public key– 1DSsgJdB2AnWaFNgSbv4MZC2m71116JafG

Private key– 19873D79C6D87DC0FB6A5778633389F4453213303DA61F20BD67FC233AA33262

You may have heard about addresses. What are they?

Your address is generated from the public keys. A mathematical function known as hashing generates the address.

But if you can get the work done with your public key why need an address?

Addresses add a layer of security to the public key and few other benefits. Even though the address, the keys are linked with each other, guessing the private key from the address or the public key is nearly impossible.

What if you lose your private keys?

You can still access your wallet even if you lose the private keys.

There is a recovery mechanism available in the form of a Seed phrase.

The seed phrase is a set of 12-24 words that help you restore lost access to the wallet.

This is how a seed phrase looks like:

“mango car bottom monitor oak nose origin parrot kind humble grit …”

The seed phrase is the only way to access your wallet if the private key is lost.

It is preferable to write down the seed phrase on paper or on something which doesn’t decay easily and store it somewhere secure.

Storing the seed phrase on a connected device is not recommended as the device might get hacked.

Types of wallets

Based on how they work, wallets are categorized into hot wallets and cold wallets.

Hot Wallet

Hot wallets are the wallets that are always connected to the internet. These types of wallets are preferred by users with frequent transactions.

They are convenient to use.

But there is a risk of a virus attack or someone getting access to the desktop or mobile where the wallet is installed.

Desktop wallet

These wallets are software installed on your desktop. Desktop wallets are comparatively more secure than other hot wallets.

Examples: Exodus, Bitcoin Core

Mobile wallet

These wallets are installed on your mobile phone.

Such wallets are preferred by those who need to access their coins on the go.

Examples:- Trust Wallet, Coinbase Wallet (Different from the Coinbase exchange app)

Web wallet

Such wallets are accessible from the web browser. There is no need to download separate software.

They offer high convenience but less security.

Examples:- MetaMask

Cold wallet

Cold wallets are not connected to the internet. They are preferred when you don’t need to access your coins frequently. People mostly use it to hold or transact large sums of funds.

Hardware wallet

These wallets are hardware devices.

It offers the highest security among all types of wallets.

To use this wallet you have to connect the device to a computer with internet access. But the user has to press a physical switch present on the device to use the wallet.

Hardware wallets are little costly as it is a hardware device. Cost ranges from ~$50-$100

Examples of few of the best Crypto wallets are Trezor and Ledger

Paper wallet

It is a method of storing private and public keys by printing them out on paper.

Paper wallets are becoming obsolete and are no longer a preferred wallet.

Conclusion

Each wallet has its strengths and weaknesses. Understand them and then decide on which wallet to use based on your needs.