What is a Crypto Wallet and How Does it Work?

2022/06/06 08:35:56

A crypto wallet can simply be defined as a storage means for digital assets. Just as a ‘real’ wallet is used to store fiat currency (USD, CNY, EUR, etc.), a crypto wallet is used - you guessed it - to store cryptocurrency. Pretty straightforward so far. But whether a user wants to buy Dogecoin, or the less volatile, and arguably much more logical Cardano, they’ll need a crypto wallet.

One of the next things to think about in understanding crypto wallets is asset ownership. Any asset owner needs a way to prove ownership of their assets. A ‘real’ wallet contains physical money. The asset owner of fiat currency simply opens their wallet to prove ownership of whichever currency they own, whether it’s Chinese Yuan, U.S. Dollars, or Malaysian Ringgit.

Since cryptocurrency is, unlike fiat currency, a digital asset, it can’t be physically held. In this case, ownership of cryptocurrency is proven by the possession of the wallet keys.

Those keys are used to prove ownership of crypto assets, and the keys themselves are unique for each separate address.

Once you understand that, then it’s time to understand the many different flavors of crypto wallets. In fact, there are many ways to categorize crypto wallets. There are hardware wallets and software wallets, custodial wallets and non-custodial wallets, and finally hot wallets, cold wallets, and paper wallets.

Hardware Wallets vs. Software Wallets

One of the most important tasks in understanding crypto wallets is simply tackling the vocabulary. And one of the broadest categorizations is the difference between hardware and software wallets.

Software wallets are based on computer software. Because they are connected to the internet, software wallets are also known as ‘Hot Wallets’.

Hardware wallets are built onto hardware devices. They are considered a much safer alternative to the software wallets. However, they also offer far less functionalities. Hardware wallets are considered a ‘Cold Wallet’ because the information they store is not accessible via the internet.

The important thing to remember here is that hardware is ‘cold’ and software is ‘hot’. There are also paper wallets, which are ‘cold’. Those are discussed below but it’s important to understand the concept of control as it relates to crypto wallets.

Custodial vs. Non-Custodial Wallets

In the world of cryptocurrency, control is key. Rather, control of your keys is key. With a custodial wallet, another party controls the key codes securing the assets.

With non-custodial wallets, the opposite is true. In a non-custodial wallet the owner controls the key codes securing the assets.

Some people find that there is a greater sense of security associated with non-custodial wallets.

Almost all exchanges provide a custodial wallet. However, users with significant crypto holdings often lessen the risk by moving said assets to a non-custodial wallet.

Bearing that in mind let’s dive back into ‘cold’ hardware wallets and ‘hot’ software based wallets.

Hot vs. Cold Wallets vs. Paper Wallets

A hot wallet is a wallet that is connected to the internet, whereas a cold wallet is one that is completely cut off from it. There are pros and cons to both types of wallets - which we’ll outline later - but first, let’s look at the sub-categories of hot wallets. After that, we’ll look at paper wallets.

Hot wallets come in three main types:

Mobile wallets: A mobile wallet is an app that runs on a smartphone and allows the user to store and control their cryptocurrency assets. Mobile wallets are convenient from the perspective that they allow the user to transfer crypto assets as payment for in-person transactions or via a QR code.

Desktop wallet: A desktop wallet is one which is installed on a desktop or laptop computer. A desktop wallet allows the user to store private keys and it also serves as an address at which the user can send and receive crypto currency. With a desktop wallet the user has increased control over their assets in comparison to the third type of hot wallet, a web wallet.

Web Wallet: Web wallets are hosted by exchanges and brokerages that offer cryptocurrency trading and related services. Web wallets can be accessed via mobile or desktop devices but offer less control than desktop wallets.

The three hot wallet types are generally free, which is an obvious point of attraction. Each of the three hot wallet types differ in slight ways. But whichever type of hot wallet a user considers the main point to remember is that hot wallets are internet connected and software-based.

Cold Wallets

Cold wallets are hardware-based devices that allow users to physically hold and carry the keys to their crypto currency assets. A cold wallet is essentially a USB flash drive with the capability of storing crypto currency asset data. Cold wallets can also be downloaded on a smartphone.

Cold wallets aren’t free since they are physical pieces of hardware. Most cold wallets cost around $100.

Paper Wallets

Lastly, there are paper wallets. Paper wallets are nearly a relic by this point in the evolution of cryptocurrency. That’s not to say that they no longer have utility, but paper wallets were more popular in the earlier years of crypto.

That explanation aside, a paper wallet is an actual printed piece of paper with a private key or QR codes printed onto it. As readers might imagine, there is inherent risk in relying on a paper wallet to secure one’s crypto assets. Damaged or torn paper wallets may be rendered useless. Likewise, a misplaced paper wallet makes the assets behind it impossible to retrieve.

Yet, the benefits make paper wallets an attractive option. Paper crypto wallets are generally very secure. Think of them not unlike a secret code you might have written on a paper as a child. As long as no one else has access to it, then it’s secure.

There is one caveat here. Because paper wallets are printed from an actual printer there can be security breaches. When printing a paper crypto wallet it is advisable to disconnect from the internet. Printers connected to larger networks may also store data. Thus, it is recommended to take caution against such potential breaches.

That was a lot of information. The overall thrust is that crypto wallets are broadly categorized: hot vs. cold, hardware vs. software, and custodial vs. non-custodial. After readers have absorbed all of that information, they’re left with a simple question: Which type of wallet is best?

Pros and Cons of Each

The answer to which type of wallet is best is of course, subjective. It depends upon what the user’s needs are. Generally speaking, there are two main needs to consider: Cost and security.

Hot wallets are digital software wallets, and as such they are almost always free. The cost to create a hot wallet is much lower than the cost to create a cold wallet. As previously mentioned, cold wallets are physical hardware and cost around $100 on average. So from the perspective of cost alone, hot wallets are the winner.

However, investors considering crypto wallets have to consider security. In this case the old maxim holds true: You get what you pay for. Hot wallets are less secure because they are hosted on the internet. Hackers can and do circumvent the security features of hot wallets.

Cold wallets on the other hand are much more secure. The small, portable pieces of hardware allow users to download their crypto assets and take them anywhere.

Cold wallets are built with security in mind. They have a reputation for being very safe and can provide a greater sense of security when compared to hot wallets. However, being that a cold wallet is a physical device, it can be misplaced or lost. Recovery is possible, but not easy.

This is the same question regarding custodial vs. non-custodial wallets. How much security are you willing to entrust to a third party?

Closing Thoughts

Remember, there is no correct answer. The answer is unique to each crypto investor. Not everyone needs the same level of security, nor the same level of functionality from their wallet.

Consider all of these factors carefully when considering which crypto wallet is right for your needs.

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