What is a Crypto Wallet? A Beginner’s Guide
Hot wallets vs cold wallets. Custodial or
non-custodial. If you are confused by the different types of crypto wallets on
the market, you have come to the right place.
Key Takeaways
- Contrary to
popular belief, crypto wallets do not physically hold cryptocurrencies
like the wallet in your pocket
- Instead, they
store the public and private keys required to buy cryptocurrencies and
provide digital signatures that authorise each transaction
- There are
several types of crypto wallets including physical devices, software, and
even paper
- Determining
which crypto wallet is best for you depends entirely on your individual
trading needs
What is a Crypto Wallet?
Cryptocurrency
wallets store users’ public and private keys while providing an easy-to-use
interface to manage crypto balances. They also support cryptocurrency transfers
through the blockchain.
Some wallets even allow users to perform certain actions with their crypto
assets such as buying and selling or interacting with decentralised
applications (DApps).
It
is important to remember that cryptocurrency transactions do not represent a
‘sending’ of crypto tokens from your mobile phone to someone else’s mobile
phone. When you are sending tokens, you are actually using your private key to
sign the transaction and broadcast it to the blockchain network. The network
will then include your transaction to reflect the updated balance in your
address and the recipient’s.
So,
the term ‘wallet’ is actually somewhat of a misnomer as crypto wallets don’t
really store cryptocurrency in the same way physical wallets hold cash.
Instead, they read the public ledger to show you the balances in your addresses
and also hold the private keys that enable you to make transactions.
Not sure what a public
or private key is?
A
key is a long string of random, unpredictable characters. While a public key is
like your bank account number and can be shared widely, your private key is
like your bank account password or PIN and should be kept secret. In public-key
cryptography, every public key is paired with one corresponding private key.
Together, they are used to encrypt and decrypt data.
Why You Need a Crypto Wallet
Your
cryptocurrency is only as safe as the method you use to store it. While you can
technically store crypto directly on the exchange, it is not advisable to do so
unless in small amounts or if you plan to trade them frequently.
For
larger amounts, it’s recommended that you withdraw the majority to a crypto
wallet, whether that be a hot wallet or a cold one. This way, you retain
ownership of your private keys and have full power and control over your own
finances.
How do Cryptocurrency Wallets Work?
As
mentioned earlier, a wallet doesn’t actually hold your coins. Instead, it holds
the key to your coins which are
actually stored on public blockchain networks.
In
order to perform various transactions, you’ll need to verify your address via a
private key that comes in a set of specific codes. The speed and security often
depend on the kind of wallet that you have.
Different Types of Crypto Wallets
There
are two main types of crypto wallets: software-based hot wallets and physical
cold wallets. Read on to learn about the different types of cryptocurrency
wallets, and which is best for you and your needs.
Hot and Cold Wallets – What’s the Difference?
Hot Wallets
The
main difference between hot and cold wallets is whether they are connected to
the Internet. Hot wallets are
connected to the Internet, while cold wallets are kept offline. This means
that funds stored in hot wallets are more accessible, and are easier for
hackers to gain access to.
Examples of hot wallets
include:
- Web-based
wallets
- Mobile wallets
- Desktop wallets
In
hot wallets, private keys are stored and encrypted on the app itself, which is
kept online. Using a hot wallet can be risky because computer networks have
hidden vulnerabilities that can be targeted by hackers or malware programs to break
into the system. Keeping large amounts of cryptocurrency in a hot wallet is a
fundamentally poor security practice, but the risks can be mitigated by using a
hot wallet with stronger encryption, or by using devices that store private
keys in a secure enclave.
There
are different reasons why an investor might want their cryptocurrency holdings
to be either connected or disconnected from the Internet. Because of this, it’s
not uncommon for cryptocurrency holders to have multiple cryptocurrency
wallets, including both hot and cold wallets.
Cold Wallets
As
introduced at the beginning of this section, a cold wallet is entirely offline.
While they’re certainly not as convenient as hot wallets, they are far more
secure. An example of a physical medium used for cold storage is a piece of
paper or an engraved piece of metal.
Examples of cold
wallets include:
- Paper wallets
- Hardware
wallets
What is a Paper Wallet?
A
paper wallet is a physical location where the private and public keys are
written down or printed. In many ways, this is safer than keeping funds in a
hot wallet, since remote hackers have no way of accessing these keys which are
kept safe from phishing attacks. On the other hand, it opens up the potential
risk of the piece of paper getting destroyed or lost, which may result in
irrecoverable funds.
What is a Hardware Wallet?
A
hardware wallet is an external device (usually a USB or Bluetooth device) that
stores your keys. You can only sign a transaction by pushing a physical button
on the device, which malicious actors cannot control.
For
any cryptocurrency assets that you do not need instant access to, the best
practice is to store them offline in a cold wallet. However, users should note
that this also means that securing your assets is
entirely your own responsibility. So it’s up to you to make sure that you
don’t lose it or have it stolen!
Tip: For increased security, separate
your public and private keys, keep them offline, and store your physical wallet
in a safe deposit box.
Hot Wallets vs Cold Wallets: Which is Better?
While
both methods of storage have benefits and drawbacks, the option you choose will
depend on what you are looking for. For example:
- If you plan to
trade day-to-day, then accessibility will be of paramount importance,
meaning that a hot wallet is probably an apt choice.
- However, if you
are considering storing a huge amount of crypto assets and value security
over convenience, then it might be wise to invest in a cold wallet.
Custodial and Non-Custodial Wallets
In
addition to the wallets mentioned above, wallets can be further separated into
custodial and non-custodial types.
Custodial Wallets
Most
web-based crypto wallets tend to be custodial wallets. Typically offered on
cryptocurrency exchanges, these wallets are known for their convenience and
ease of usage, and are especially popular with newcomers, as well as
experienced day traders.
The
main difference between custodial wallets and the types mentioned above is that
users are no longer in full
control of their tokens, and the private keys needed to sign for
transactions are held only by the exchange.
The
implication here is that users must trust the
service provider to securely store their tokens and implement strong security
measures to prevent unauthorised access. These measures include two-factor authentication,
email confirmation, and biometric authentication, such as facial recognition or
fingerprint verification. Many exchanges will not allow you to make
transactions until these security measures are properly set up by the user.
Exchanges
and custodial wallet providers will usually also take further steps to ensure
the safety of users’ tokens. For example, a portion of the funds is usually
transferred to the company’s cold wallet, where they can be safe from online
attackers.
At Crypto.com, we have taken many measures to ensure the protection of customer funds. After rigorous
security audits by a team of cybersecurity and compliance experts, Crypto.com
is the first crypto company in the world to have obtained ISO/IEC 27701:2019,
ISO22301:2019, ISO27001:2013
and PCI:DSS 3.2.1, Level 1 compliance, and independently assessed at Tier 4,
the highest level for both NIST Cybersecurity and Privacy Frameworks, as well
as Service Organization Control (SOC) 2 compliance.
Additionally,
we have in place a total of US$360 million for insurance protection of customer
funds.
Non-Custodial Wallets
Non-custodial
wallets, on the other hand, allow you to retain full control of your funds
since the private key is stored locally with the user.
When
starting a non-custodial wallet, you will be asked to write down and safely
store a list of 12 randomly generated words, known as a ‘recovery’, ‘seed’, or
‘mnemonic’ phrase. From this phrase, all of your public and private keys can be
generated. This acts as a backup or a recovery
mechanism in
case you lose access to your device.
Anyone
with the seed phrase will be able to gain full control of the funds held in
your wallet. In a case scenario where the seed phrase is lost, you will lose
access to your funds. So it is imperative to keep the mnemonic phrase in a
secure location, and to not store a digital copy of it anywhere! Do not print
it out at a public printer or take a picture of it with your phone.
Note
that hardware wallets are inherently non-custodial since private keys are
stored on the device itself. There are also software-based non-custodial
wallets, such as the Crypto.com Wallet. The common theme here is that the
private keys and the funds are fully in users’ control. As the popular
saying within the crypto community goes, ‘not your keys, not your coins!’
On
the flip side, however, this means that users must be in charge of their own
security, with regard to the storage of passwords and seed phrases. If any of
these are lost, recovery can be difficult or impossible since they are
typically not stored in any third-party server.
Custodial vs Non-Custodial Wallets: Which is Better?
Custodial
and non-custodial wallets have different pros and cons that make them suitable
for different types of users:
- If you are
prone to losing passwords and devices, then it makes more sense to use a
custodial wallet, since an exchange or custodian is likely to have better
security practices and backup options. That’s why it’s a popular option
for beginners who have little to no experience trading crypto. Further,
transaction fees with a custodial wallet tend to be cheaper or even
free.
- However, if you
prefer to retain full control over your own funds, you might want to
consider a non-custodial wallet.
Ultimately,
it all comes down to your choice.
For Additional Security, Consider Multi-Signature Wallets
Multi-signature
wallets – or multisig wallets – are wallets that require two or more private
key signatures to authorise transactions. This solution is useful for a number
of use cases:
- An individual
using a multisig wallet can prevent losing access to the
entire wallet in a case scenario where one key is lost.
For example, if a user loses one key, there will still be two other keys
that are able to sign transactions.
- Multisig
wallets can prevent the misuse of funds and fraud, which makes them a good
option for hedge funds, exchanges, and corporations. As
each authorised person will have one key and a sign-off requires the
majority of keys, it becomes impossible for any individual to unilaterally
make unauthorised transactions.
Any
of the wallet types described above have multisig versions. You can have
multisig hot wallets, cold wallets, hardware wallets, and so on.
Which Crypto Wallet Should You Use?
When
it comes to crypto wallets, there is no perfect solution. Each type of wallet
has different strengths, purposes, and trade-offs. So it’s really up to you to
weigh up what works best for you and your specific needs.
- For those with
a high risk tolerance who want to make regular, quick online payments, the
convenience of a hot wallet would suit you best.
- But if you’re a
little more gun-shy and intend to hold your coins long-term, then a secure
offline device might make the most sense.
- And if it’s the NFT market
that you’re interested in, then you need to look for a wallet that is
compatible with NFT marketplaces such as OpenSea, Solanart, and Crypto.com.
When
choosing a crypto wallet, there are certain factors you should take into
consideration. These include:
- Software vs hardware
- Security features
- How user-friendly it is
- Fees
- Supported coins
- Platform compatibility
- Whether you need DApp and
DEX integration
- Whether the wallet has
backup options
- The wallet’s reputation and
longevity on the market
As
storing large quantities of coins in a single wallet is quite risky, a
combination of cold and hot wallets is usually ideal, and can help you
strike the right balance between convenience and security.
The final
choice remains yours, with the non-custodial Crypto.com Defi Wallet one
of many secure options.
