As cryptocurrencies gain popularity more and more people are considering the question of how to store them. While its initially fine to choose any storage option as users become more experienced they become more discerning, in selecting the place to safeguard their crypto assets.
Now lets briefly explore how crypto wallets operate and then delve into the distinctions between types of cryptocurrency wallets. By understanding these differences you’ll be able to choose one that suits your needs.
Cryptocurrency Wallet Functions
A crypto wallet is software that stores public keys while facilitating interactions with blockchain networks for sending and receiving cryptocurrencies. A private key is a large sequence of characters and numbers used to prove ownership of a cryptocurrency when interacting with the blockchain. Hence crypto wallets act as interfaces through which cryptocurrency owners engage with blockchain networks—making them an essential component of the cryptocurrency ecosystem.
Crypto wallets fulfill tasks such, as sending, receiving and tracking ownership of cryptocurrencies. They enable users to track transaction history, handle cryptocurrencies and maintain balances effectively.
Crypto wallets do not directly store cryptocurrencies. They securely hold the private keys that grant access, to the blockchain network where the cryptocurrencies are stored. This means that you can have backup copies of your wallets (in the form of the seed phrase that was used to create the wallet), and in case of loss or breakdown of your smartphone or hardware crypto wallet, you can restore access to your assets on a new device – Usually a seed phrase is used for this, the safety of the seed phrase from prying eyes should be protected in the same way as your private keys.
How Cryptocurrency Wallets Work?
Cryptocurrency wallets operate on technology, which’s a decentralized ledger recording all transactions within it. The blockchain network comprises verified blocks added by miners through mechanisms like Proof of Work or Proof of Stake.
Cryptocurrency wallets interact with the blockchain network by creating and digitally signing transactions using keys. These transactions are then broadcasted to the network for verification by miners and eventual inclusion, in the blockchain. Essentially cryptocurrency wallets provide a user interface for individuals to engage with the blockchain.
Types of Cryptocurrency Wallets
As tools facilitating user interaction with blockchains crypto wallets can be implemented in ways differing in details:
- How private keys are stored and who has access to them – custodial and non-custodial.
- Whether the crypto wallet has constant internet access or only connects when making transactions – hot and cold wallets.
Let’s describe the established types of crypto wallets in more detail:
Custodial vs. Non-custodial cryptocurrency wallets:
Custodial wallets are wallets where the service provider (the developer of the crypto wallet application) manages your private keys, while non-custodial wallets allow you to manage your own private keys. Since custodial wallets provide the convenience of key management by the service provider, their use comes with security compromises. Non-custodial wallets provide a higher level of security as you have full control over your private keys.
Custodial cryptocurrency wallets are wallets in which the wallet application developer or the cryptocurrency storage service provider (such as a cryptocurrency exchange) has access to your private keys. Using such a wallet is a compromise in terms of security, as in the event of any malfunctions or hacker attacks on the service provider, your assets will be at risk. Roughly speaking, hackers only need to attack one place, even if it is well protected, to gain access to users’ exchange private keys. This makes custodial cryptocurrency wallets a tempting target for hackers.
Non-custodial cryptocurrency wallets, in turn, are designed in such a way that the developer cannot in any way access the user’s private keys or passphrase. In this case, the private keys are stored only on the user’s device and nowhere else.
Details of Non-Custodial Wallets
During the creation of a new non-custodial cryptocurrency wallet, the user needs to enter a passphrase – a password phrase (seed phrase) consisting of a certain number of words in a specific sequence, with the last word in this sequence acting as a verification (checksum).
You can learn more about this process in the BIP39 standard description.
After the passphrase is chosen, the cryptocurrency wallet generates a set of private keys based on it for the supported cryptocurrencies. A private key is what allows you to prove to the blockchain that you own the cryptocurrency at a specific address.
These private keys are then used when you make transactions using the cryptocurrency wallet.
Comparing different types of wallets
Now, understanding the differences between custodial and non-custodial cryptocurrency wallets will make it easier for us to navigate through their variations:
Hot and cold crypto wallets.
A cryptocurrency wallet can be implemented either as a standalone application for computers or smartphones, or in the form of a device that stores private keys. Any cryptocurrency wallet app, regardless of the platform, is considered a hot wallet, with “hotness” referring to its constant internet connectivity.
A cold cryptocurrency wallet, on the other hand, is the direct opposite of a hot wallet. It can be implemented without the need for internet connectivity, or only connected to the internet when a transaction is being made and confirmed by the user. This is due to the cybersecurity concept called air-gap, which states that a device is not susceptible to hacking as long as it is disconnected from the internet.
Cold cryptocurrency wallets can resemble flash drives, credit cards with small screens and buttons, or even small smartphone-like devices.
Online (Web) cryptocurrency wallets
Any application can be implemented in the format of a website, and crypto wallets are no exception to this rule. Such crypto wallets are more susceptible to attacks, and if you have to use them, it is recommended to keep the balance of such wallets as low as possible with all security measures enabled.
Mobile Crypto wallets
Mobile application wallets are the most popular type of cryptocurrency wallets for smartphones. In all cases, these wallets are considered hot wallets, whether they are custodial or non-custodial.
Naturally, people strive for convenience and using their smartphones for their intended purpose. And as long as we’re not talking about storing very large amounts of cryptocurrency, mobile wallets provide more than enough functionality. Examples of mobile wallets include Arctic Wallet, Atomic Wallet, Trust Wallet, and Coinbase Wallet.
Cryptocurrency exchange as a wallet
To use the capabilities of a cryptocurrency exchange, you need to deposit funds into your account within that exchange. This requires a cryptocurrency wallet, and when it comes to exchanges, such a wallet will always be under the control of the exchange.
In essence, when you deposit funds into such a cryptocurrency wallet, they fall under the responsible custody of the cryptocurrency exchange – in other words, the wallet of your account on the exchange is custodial. This exposes your funds to additional risk, as cryptocurrency exchanges are a prime target for hackers.
Furthermore, your account on the exchange, along with the funds within it, can be frozen for various other reasons. When using such a solution, keep in mind the popular phrase, “not your keys, not your cryptocurrency.”
On the other hand, if you are an active cryptocurrency trader and execute a large number of transactions throughout the day, placing your funds on the exchange’s deposit is a natural step. Otherwise, the level of fees would increase to an unacceptable level.
Now you have a better understanding of the variety of cryptocurrency wallets available, and it should be easier for you to make a choice that suits your needs.
For beginners, custodial hot wallets, especially cryptocurrency exchanges, are the best option to get acquainted with cryptocurrencies.
Crypto investors prefer cold wallets as a more secure way to store their investments long-term without any external access to them.
Non-custodial cryptocurrency wallets are the choice of advanced users who want full control over their private keys, without the need to carry an additional device and ensure its safety and security.