Buy Crypto
Markets
Contract
Spot
Earn
Web3 new
Learn

What is a Crypto Wallet? How does it Work?

2023-11-11 02:23:18

A cryptocurrency wallet operates as a digital wallet for your digital currencies. Analogous to a physical wallet that holds cash and cards, a cryptocurrency wallet holds the digital keys necessary for signing cryptocurrency transactions and accessing your digital funds.

Cryptocurrency wallets have democratized the use of blockchain technology. Initially, transacting with cryptocurrency required manually inputting extensive keys. Now, wallets simplify this process through automation.

The very first cryptocurrency wallet was in the possession of Bitcoin's creator, Satoshi Nakamoto. Following him was Hal Finney, an early adopter who also ran the Bitcoin client software wallet. Nakamoto's transfer of 10 bitcoins to Finney marked the inception of the widespread cryptocurrency movement.

Types of Cryptocurrency Wallets

There are primarily two categories of wallets: custodial and noncustodial. Custodial wallets are managed by a third party which safeguards your keys—often provided by companies with advanced data security systems or cryptocurrency exchanges for their users. Noncustodial wallets, on the other hand, place the onus of key security on you and are the typical variety found on personal devices.

Further, wallets are classified as hot or cold based on their internet connectivity. Hot wallets are connected to the internet or to internet-enabled devices, whereas cold wallets operate offline. Additionally, wallets come in three forms: software, hardware, and paper—each can be designated as hot or cold.

Therefore, it's possible to possess a noncustodial software hot wallet, a noncustodial hardware wallet that can be either hot or cold, or a custodial hardware cold wallet. While these configurations are standard, there are other potential variations.

Software Wallets

Software wallets are available as applications for both desktop and mobile platforms. Desktop-based wallets offer access to your cryptocurrency, enabling transactions, balance inquiries, and more. Certain software wallets may also integrate additional features such as built-in exchanges, particularly if they are developed by a cryptocurrency exchange.

Mobile wallets facilitate swift payments in stores via near-field communication (NFC) technology or QR code scanning. They are designed to be compatible with either iOS or Android systems. Examples of such wallets include Trezor, Electrum, and Mycelium. Typically, software wallets are considered to be hot wallets due to their internet connectivity.

Hardware Wallets

Hardware wallets have gained popularity as a secure means to store private keys offline. These devices, which are similar in appearance to USB drives, come with a host of features for enhanced security.

To execute a transaction, you connect the hardware wallet to your computer or another device. Most hardware wallets are designed to sign transactions automatically, thereby protecting against the risk of keylogging or screen capture by malicious entities.

These wallets typically range from $100 to $200 in price, with Ledger and Trezor being among the most recognized brands. Generally, hardware wallets are considered cold wallets because they remain offline until connected to a device.

Paper Wallets

Initially, paper wallets were simply physical documents containing a user’s keys and QR codes for easy scanning by mobile devices. Despite their simplicity, paper wallets pose risks as they can be easily damaged or misplaced, leading to a decline in their usage.

Nonetheless, paper wallets can be effective if properly safeguarded, such as by storing them in a secure location like a safe or safety deposit box and regularly checking their condition.

Securing Your Crypto Wallet

Ensuring the security of your cryptocurrency wallet is paramount, given the attractiveness of these assets to hackers. Protective measures include wallet encryption with robust passwords, employing two-factor authentication on exchange platforms, and keeping substantial holdings in offline storage.

The Importance of Seed Words

Modern wallets generate a seed phrase, often consisting of twelve mnemonic words, such as "airport bedroom impression sample reception protection road shirt..." While this sequence appears arbitrary, it is algorithmically generated and linked to your unique keys. This seed phrase is crucial for wallet recovery in case of device loss or damage and should be kept in a secure location, as possession of these words can grant access to your cryptocurrency.

Considerations for Cryptocurrency Exchanges

Many cryptocurrency exchanges now offer to store users' keys as a custodial service. While convenient, the use of such services should be approached with caution. Exchanges are prime targets for cyber-attacks, and there may be no recovery of your assets if the exchange goes defunct.

Examples of Crypto Wallets

Here's a look at some notable hardware wallets available:

NGRAVE

Emerging as a new player in the field, NGRAVE has been nurtured by a premier security research firm, imec. The device, known as the “coldest wallet,” is designed to be completely offline, eschewing USB or Bluetooth for one-way QR code communication to maintain security. It also features a durable, fire and water-resistant backup for the seed phrase, using stainless steel sheets rather than the conventional paper backup.

Ledger Hardware Wallet

The Ledger Nano X is crafted by a French startup and encased in a steel shell, resembling a traditional USB drive. It can connect to devices via USB or Bluetooth, offering convenience and an upgrade from its predecessor, the Ledger Nano S. Supporting a wide range of cryptocurrencies, Ledger Nano X enjoys popularity backed by the company's extensive marketing efforts.

Trezor Hardware Wallet

Satoshi Labs' Trezor Model T introduces a touchscreen interface, setting it apart from others. It supports a vast array of cryptocurrencies and provides a user-friendly experience for storing digital assets.

Examples of Hot Wallets

Hot wallets represent the software side of crypto wallets, known for their connectivity to the internet. Below are some examples:

MetaMask

MetaMask, created by Aaron Davis and Dan Finlay in 2016, is a digital wallet aimed at simplifying the interaction with Ethereum’s blockchain. It functions as a browser extension, linking browsers like Chrome or Firefox to the Ethereum network, enabling users to engage with DApps without a full node.

Coinbase Wallet

Coinbase Wallet gives users complete control over their private keys and thus their cryptocurrency assets. Unique from the Coinbase exchange, it supports a multitude of cryptocurrencies and provides additional features like participating in airdrops, ICOs, accessing DApps, and managing digital art like NFTs. It's known for its robustness and user-friendly interface, though it may incur fees for certain transactions and conversions.

Edge Wallet

Edge is a mobile wallet prioritizing ease of use and security, employing client-side encryption to ensure users' private information and digital assets are self-managed. It offers a seamless interface for trading and managing cryptocurrencies, with integrated exchanges for optimizing trades directly within the wallet. Edge's commitment to privacy and user autonomy, coupled with its intuitive design, make it a commendable choice for mobile cryptocurrency management.

How to choose the best crypto wallet?

For newcomers, the initial option for a cryptocurrency wallet is usually an online wallet provided by their crypto exchange for purchasing and trading digital currencies. This may seem convenient, but it isn't always the optimal choice for everyone. Keep these considerations in mind when selecting the most suitable cryptocurrency wallet:

Hot vs. Cold Storage

A hardware wallet represents an offline mode of securing cryptocurrency, appealing to those with heightened concerns about the vulnerability of online platforms, desktop, or mobile applications to cyber-attacks, including hacking or ransomware threats. The trade-off for using a hardware wallet is its lack of constant availability and immediate online access, which can make it somewhat less user-friendly.

Safeguarding Assets

Security should be the main concern for hot wallets. Select a cryptocurrency wallet that ensures robust security measures, particularly one that supports multifactor authentication.

Compatibility with Various Blockchains

For those interested in transacting with a particular digital currency, it's crucial to ensure that the wallet you select is compatible with the blockchain technology of that cryptocurrency.

Ease of Integration and Usage

It's important to verify that the crypto wallet of choice can be easily integrated and is supported by the cryptocurrency exchange you use, beyond the support for specific cryptocurrencies.

Inheritance and Cryptocurrency Wallets

Cryptocurrencies are considered assets upon an individual's passing, similar to traditional assets that go through the probate process before distribution to heirs. It's essential for the owner to include their cryptocurrency in their estate plan for a smooth transfer to the beneficiaries upon death.

However, accessing a crypto wallet posthumously requires the private key. Without knowledge of this key, the cryptocurrency may become inaccessible. To prevent such a scenario, there are several strategies one can employ:

  • Documenting the passkey of the crypto wallet. This can be detailed in a will, noted down, or communicated to the potential heirs. Due to security risks like theft, it's advisable to store digital account information securely, for example, in a password manager.
  • Transferring the cryptocurrency to an exchange. Some exchanges offer a secure vault service for storing private keys, functioning like a safety deposit box.
  • Creating a joint account with an exchange. This facilitates a seamless transition of cryptocurrency assets to heirs.
  • Designating a beneficiary through the exchange. This ensures that the exchange transfers ownership of the account to the intended beneficiaries after the owner's demise.
  • Establishing a trust account. Trusts bypass the probate process and clearly define the inheritance process for assets, including digital currencies. The trust should contain detailed instructions for wallet access.

In divorce proceedings, it is crucial to classify cryptocurrency as an asset rather than income in financial statements. Given the volatile nature of cryptocurrency value, it is important to account for its fluctuating worth when appraising assets. The division of cryptocurrency in a divorce follows the same principles as other assets and is subject to state laws.

giftRegister to get $180 Welcome Bonus!
Email
Password
Invitation code (Optional)
  • Facebook
  • Twitter
  • LinkedIn
  • Telegram
  • Discord
  • Youtube
Subscribe Phemex

Register on Phemex and begin your crypto journey today

Get $180 to Sign Up

Bonus

Become the First PT Holders with ZERO Risk

Celebrate the Launching of the Phemex Token on November 30th