A crypto wallet is a program, software or system for storing public and private keys. It allows you to interact with the blockchain and to send, receive, store and monitor your cryptocurrencies. Unlike a traditional physical wallet that holds your fiat, cards and IDs, a crypto wallet is a key to accessing your funds on a distributed blockchain. So, technically speaking, a crypto wallet does not store your asset. It only provides you with the information needed to access your funds.
How do cryptocurrency wallets work?
A perfect analogy to understand how crypto wallets works is to look at a typical traditional banking system where your bank is the blockchain, your fiat is the digital asset, your bank account number is your public key, and your mobile bank app is your crypto wallet, and your mobile app login details are your private key.
With your mobile app, you can track the activities on your account, send and receive funds. To access your account, you need to input your login details. This is similar to how you can access your crypto wallet using the private keys to track your asset send and receive assets.
Traditionally, if you want to receive money from someone, you only send them your bank account address which is similar to sharing your crypto public address. Just like you would never disclose your banking login details, never share your private key with anyone, as you would be handing over all your funds to them. Just don’t do it.
Public vs. Private Keys
With the analogy above, you now have a fair understanding of how crypto wallets work. Now, let’s talk about the public and private keys.
A public key is a string of numbers of letters used to create publicly viewable crypto wallet addresses. It is automatically created when you set up a cryptocurrency wallet.
The private key is not publicly viewable and is used to send cryptocurrencies out of your crypto wallet. It is also a complex string of numbers and letters represented by 12 or 24 randomly generated words also known as seed phrases. Because these seed phrases make up the private keys, they can be used to recover the cryptocurrencies contained in any crypto wallet created by the private key’s associated public key. The seed phrases are first shown to you when you set up an account; after that, it becomes your responsibility to safeguard your private keys or the seed phrases.
Crypto custody: custodial vs. non-custodial wallets
The gospel of blockchain technology and cryptocurrencies borders on decentralization and giving people access and control over their own finances. For this reason, crypto wallets are broadly classified as custodial or non-custodial wallets, depending on who holds the private keys.
Custodial crypto wallets
As the name implies, a custodial wallet is one where your private keys are held and managed on your behalf by a third party. This is usually the company that created the wallet, like Coinbase or Binance. With a custodial wallet, you do not have full control over your assets, but this has its own advantages. For example, a custodial wallet relieves you of the responsibility of securing your private keys. It is more convenient and less risky. In an instance where you forget your password, you can access your account by contacting customer support for assistance.
If you prefer to go with a custodial wallet, be sure to check if the service providers are regulated, the type of service that you will get, how the private keys are stored and if there is insurance coverage.
With a non-custodial wallet, you have your private keys and full control over your assets. You can move your assets out of the wallets associated with the private key via the public address.
Non-custodial wallets can either be hot or cold. A non-custodial wallet is described as a hot wallet if it is connected to the internet. They are mobile and or web-based software. Examples are Metamask, Trust Wallet, MyEther Wallet and Exodus Wallet. Hot wallets are relatively secure, but because they are connected to the internet, they can be compromised by hackers.
A cold wallet is completely disconnected from the internet. They are hardware devices that look similar to flash drives. Compared to hot wallets, they are more secure and hack-resistant. Examples of cold wallets are Trezor, ledger, and Keep Key wallets. The advantage of a cold wallet is that you are in full control of your private key and assets, but the risk is that if you lose access to your private key, you lose access to your assets permanently.
In addition to the standard crypto wallets, there are also the lesser-known multiple signature wallets. Unlike the standard crypto wallets that require only one key to authorize all outgoing transactions, multi-sig wallets require more than one key. Based on the configuration of the wallet, there can be different key combinations such as;
- 2-of-2: Both signatures are required to access a 2-signature wallet
- 2-of-3: Two out of three signatures are required to access a 3-signature wallet
- 3-of-3: All signatures are required to access a 3-signature wallet
- 3-of-4: Three signatures are needed to access a 2-signature wallet
Multi-sig wallets are preferred for their enhanced security and can serve as a form of 2-factor authentication for users holding private keys on multiple devices. There are certain risks associated with multi-sig wallets, including;
- Need for technical knowledge in setting it up
- Slow transaction speed compared to single-signature wallets and
- The lack of a third-party custodian to enforce trust
How to choose the best crypto wallet for your needs
The choice of the best crypto wallet depends on your specific needs. There’s no size fits all response. Most people combine wallets. You can use a custodial exchange for trading, a mobile wallet for daily transactions, and a hardware wallet can be used to secure most of your assets.