What Are Crypto Wallets And How Do They Work?

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Senior Writer

Published Jul 31, 2023 at 11:47 AM
Last updated May 8, 2024 at 1:39 PM

A crypto wallet is your private vault for protecting your priceless digital possessions in the broad world of cryptocurrencies. You may store, manage, and interact with your Bitcoin using it as a high-tech piggy bank.

Key takeaways

  • A crypto wallet securely holds your private keys, granting you control over your assets on the blockchain.
  • Your public key is like your address to receive crypto, while your private key is like your PIN, authorizing transactions.
  • Hot wallets offer online convenience but are more vulnerable. Cold wallets prioritize security with offline storage.
  • Custodial wallets (e.g., those offered by crypto exchanges) manage keys for you, while non-custodial wallets give you full control over keys.
  • While choosing a crypto wallet, factor in security needs, desired features, and your comfort level with managing private keys.

What is a crypto wallet? Crypto wallets explained

Crypto wallets are tools that enable users to access and manage their cryptocurrency holdings on the blockchain by securely storing their private keys.

A crypto wallet may appear to be like a digital vault or safe to keep your hard-earned cryptocurrencies. However, the truth is much more complex. In the decentralized realm of blockchain technology, crypto wallets serve a far more important purpose than secure storage.

Consider a cryptocurrency wallet as a link between you and the distributed ledger, or blockchain, which houses all of the crypto transactions. But you might want to know where is cryptocurrency stored?

The simple answer is that in contrast to a conventional wallet that retains tangible currency, a cryptocurrency wallet does not 'store' your coins. Rather, it safely stores the private keys that function as your blockchain-based digital signature. 

Now, you might be confused about how to ensure a crypto wallet security is effective enough to protect your funds. Think of it like your publicly available bank account number, which is analogous to your public key. 

You can receive cryptocurrency at this address from anybody. However, the only thing that may approve any withdrawals or transfers is your private key, which is the same as your PIN.

Furthermore, be informed that cryptocurrency wallets do more than just protecting your digital assets; they enable you to engage in a variety of interactions with the blockchain ecosystem. Using your wallet, you can:

  • Receive cryptocurrency: Your public address is where anyone may send you cryptocurrency.
  • Send cryptocurrency: Use your private key to digitally sign transactions to get them started.
  • Manage your assets: Keep tabs on specific transactions and your total crypto amount.
  • Engage with dApps, or decentralized applications: Through your wallet, you can have direct access to an expanding array of dApps, including gaming platforms and DeFi (decentralized financial) services.

Although the fundamental features of cryptocurrency wallets are the same, they are available in many forms to meet different requirements and security preferences. Consider multiple options to see which best suits your investing style and comfort level before selecting one.

Public key and private keys explained

A secure algorithm is used to establish a mathematically connected pair of keys — a public key and a private key — when you create a cryptocurrency wallet.

With the use of a one-way cryptographic function, the public key is obtained from the private key. Security is ensured by the near impossibility of deriving the private key from the public key.

If you want to know how to use crypto wallet, it's first important to understand public and private keys. Let’s delve into these two types of keys in the below section.

What is a public key?

Envision a thriving market brimming with virtual assets - the realm of cryptocurrencies. You must have a method of obtaining these priceless coins and tokens to take part in the crypto ecosystem. 

This is when your public key comes into the picture. Consider it your own public address in this digital marketplace. You can publicly share this string of alphanumeric characters with whomever (as indicated by its name). Your public key enables people to send you cryptocurrency, much like having a public postal address enables them to send you letters.

Crypto can be sent to your public key address by anyone in the world. Comparable to giving you your mailbox key, anyone can add something to it, but they are unable to access items that are already inside. 

It simply acts as a designated location to receive your crypto assets; your security is unaffected by sharing your public key. But a public key is derived?

Through a sophisticated cryptographic process, the public key is hashed and mathematically generated from your private key (described in the below section). You can easily distribute your public key without disclosing the more sensitive private key due to this one-way mechanism.

When someone transfers cryptocurrency to your wallet address, they are essentially "locking" those funds with a mathematical puzzle that can only be solved with your private key.

What is a private key? 

In the cryptocurrency market, consider your private key to be the master key to your digital vault. Consider it as a lengthy string of characters that need to be kept completely confidential. Similar to a bank account PIN, this private key gives you sole authority over the coin linked to its matching public key.

Any transaction you wish to authorize requires the use of the private key. You digitally sign transactions with your private key while sending cryptocurrency. This signature effectively confirms that you are authorized to transfer those funds, serving as a cryptographic evidence of ownership. The blockchain network wouldn't approve the transaction if your private key wasn't used to sign it.

At this point, you might want to understand how do crypto wallets work behind the scenes. Be aware that you need to start a transaction in your wallet to transmit crypto. The recipient's address, the transaction fee, and the amount are all assembled by the wallet software.

This is where the magic lies: This transaction has been digitally signed by your wallet using your private key. The transaction data and your private key are used to create a unique code that serves as the signature. This signature and the transaction are sent out to the blockchain network.

The network's miners (or validators, depending on the blockchain) check the transaction to make sure the signature is legitimate and you have enough funds. The network mathematically confirms that the signature was created with the matching private key by utilizing the public key linked to your sending address.

The transaction is added to the blockchain and the ledger is updated to reflect the transfer of your cryptocurrency if the signature is verified.

Crypto wallet security is crucial when dealing with private keys. Losing your private key results in permanent loss of access to your crypto assets; just like losing the key to a physical safe won’t give you access to your tangible assets. 

Your digital assets are lost as soon as your private key is lost; there are no recovery procedures in place. Because of this, it's essential to keep your private key safe and not give it to anybody.

Types of crypto wallets – how many are there?

Various crypto wallets exist but there are realistically two types of crypto wallets:

  • Hot wallets
  • Cold wallets

With the above-listed categorization, you might wonder what is BTC wallet. Let's decode that a BTC wallet is specifically designed to hold and manage Bitcoin. You must obtain cryptocurrency from an exchange or another user to use a crypto wallet or any BTC wallet, and you can transfer or exchange funds using your wallet.  

The below sections will explain various types of crypto wallets in detail.

What is a hot wallet?

Hot wallets are online wallets meant for cryptocurrency users dealing in small amounts of cryptocurrency; they prioritize functionality and convenience of use. They provide an easy-to-use interface for transferring, receiving, and managing your crypto holdings because they are always online. Here's a closer look of the primary hot wallet subtypes:

Web wallets

Arguably, a web wallet is the most easy-to-use kind of a crypto wallet. Cryptocurrency exchanges or companies that offer specialized wallets host them online. They are instantly accessible through your web browser, so you may access them from any internet-connected device.

Creating an online wallet is frequently a straightforward procedure. You may open an account and create a wallet on many exchanges. They are a good starting point for newbies because of their ease of usage.

One excellent example of a Web3 wallet is MetaMask. With the help of a browser extension (as shown in below image), users may communicate with the Ethereum blockchain and its network of dApps right from their browser.

What is a crypto wallet

One important distinction is that you usually don't keep your private keys directly when using web wallets. That is the exchange's or the provider's obligation. This makes dealing with crypto wallets easier, but it also puts your assets in the hands of a third party. Remember, “not your keys, not your coins.”

Desktop wallets

A middle ground between cold storage and web wallets is provided by desktop wallets. On your desktop computer, you can download and install these software programs. Unlike web wallets, you have more control over your cryptocurrency since you own your private keys.

Exodus Wallet, which enables users to safely store, manage, and exchange different cryptocurrencies straight from their desktop PCs, is an example of a desktop wallet.

When it comes to functionality, desktop wallets are more advanced than web wallets. They might come with built-in features like staking (being rewarded for holding a certain cryptocurrency), advanced trading choices, and blockchain application interaction.

Even while desktop wallets provide you more control, they are still online. It's critical to back up your private keys safely, install robust security measures on your computer, and use reliable software.

Mobile wallets

These are mobile apps made especially to help you keep track of your cryptocurrency holdings. Portability and accessibility are given priority in mobile wallets. You may send, receive, and keep track of your cryptocurrency balance directly from your phone using your mobile wallet.

Trust Wallet (also available as a browser extension), which enables users to safely store, transmit, receive, and exchange different cryptocurrencies straight from their mobile devices, is an example of a mobile wallet.

For regular transactions or buying cryptocurrencies, mobile wallets are perfect. They frequently have mobile-friendly interfaces that make them easy to use while on the road.

However, there is an inherent risk involved with using a hot wallet that is linked to the internet, just like with desktop wallets. Mobile wallets should always be downloaded from reliable sources (such as app stores), and secure passwords should always be your first priority.

Crypto Wallets Types

What is a cold wallet?

The private keys that safeguard your digital assets are best protected via cold wallets, which provide offline storage options. Below are the various types of cold wallets available in the cryptocurrency market:

Hardware wallets

Hardware wallets, which resemble USB devices, keep your private keys safe and secure in a separate location. Compared to hot wallets that are connected to the internet, this offline feature greatly lowers the possibility of hacking.

Credible hardware wallets frequently have extra security features like two-factor authentication and PIN codes, which add further layers of defense.

Hardware wallets are simple, yet they are made with security in mind. The majority of hardware wallets have simple software and user-friendly interfaces for managing your cryptocurrency holdings.

The Trezor Model One and Ledger Nano S are two well-known hardware wallets. These devices usually offer safe transaction signature features and support a large number of coins.

Paper wallets

Paper wallets handle cold storage with simplicity; they entail creating your public and private keys offline and printing them out on paper (usually as QR codes). 

Using premium paper and laminating the printout to safeguard it from deterioration are recommended to keep your paper wallets safe for lifetime. It is essential to keep backups in safe places in case the original one is destroyed.

Although paper wallets provide offline security, using them to manage transactions might be difficult. You greatly lessen the possibility of malware, phishing scams, and cyber attacks breaching your assets by keeping your private keys offline. For long-term investments (HODLing) or for storing huge amounts of cryptocurrencies, cold storage is especially advised.

To sign transactions offline, you usually need to use a computer and a separate piece of software. You may also lose access to your funds permanently if you misplace or compromise your paper wallet.

What is a custodial wallet?

Cryptocurrency market offers a world full of digital assets ready to be purchased, sold, and held. Custodial wallets serve as a gateway to this market, providing a user-friendly interface with a crucial distinction: your digital vault's keys are kept in the hands of a reliable third party called a custodian.

Consider it analogous to a conventional bank account. Your money is deposited, and it is safely managed by the bank. In a similar vein, you move your crypto to a platform or an exchange like Coinbase using a custodial wallet. Your private keys, which are essential security credentials that unlock your cryptocurrency assets, are stored on this platform, which assumes responsibility for their protection.

Custodial wallets put an emphasis on user-friendliness, which makes them perfect for novices or people who prefer a simplified interface. Creating an account on a cryptocurrency exchange is frequently the easiest way to set up a custodial wallet. 

These platforms take care of the complicated private key administration so you can concentrate on purchasing, disposing of, and managing your cryptocurrency holdings. To add even more ease, some custodial wallets provide methods for recovering your account in the event that you misplace your login information.

Custodial wallets provide an easy way to start, but you should be aware that you are entrusting a third party with your money. This implies that the strong security measures of the exchange will ultimately determine how secure your cryptocurrency is. 

Your crypto holdings may be at risk if hackers gain access to their systems. Furthermore, custodial platforms have their own set of guidelines and policies, which can affect how you access or utilize your cryptocurrency holdings in the future.

What is a non-custodial wallet?

Non-custodial wallets provide an alternative paradigm for individuals who prefer total control and rely upon "be your own bank" strategy. Your private keys will be under your control, if you utilize a non-custodial wallet.

These intricate coding strings serve as your digital vault's master password. With non-custodial wallets, you have the authority and means to safely handle your private keys. Your crypto assets can be bought, sold, and transferred directly by you, without the need for a middleman. 

Software wallets that can be downloaded to your computer or smartphone are popular choices of non-custodial wallets, as are hardware wallets, which are actual devices that look like USB drives. 

A big responsibility that goes along with this independence is to safely store and backup your private keys. Without any recovery options, losing your private keys means you'll never be able to access your cryptocurrency assets again.

Which type of wallet is best?

There's no single "best" type of crypto wallet or "one-size-fits-all approach," as it depends on your understanding of how do crypto wallets work, your individual needs and priorities. In addition, you need to look for a trade-off between the control and security offered by various types of crypto wallets.

That said, the ideal hot wallet depends upon your needs under consideration. Think about below factors before choosing a hot wallet:

  • Concerns about security: How much authority do you wish to have over your private keys?
  • Features: Do you require the ability to stake or advanced trading options?
  • Accessibility: What is the significance of having mobile cryptocurrency access?

Similarly, your level of comfort with security and technological proficiency will determine which cold wallet is best for you:

  • Hardware wallets: For individuals looking for a more practical offline storage option or with greater cryptocurrency holdings, hardware wallets offer an excellent combination of superior security and user-friendliness.
  • Paper wallets: An inexpensive choice best suited for tech-savvy individuals who value complete offline protection and are at ease with a more manual process.

Likewise, your priorities will ultimately determine which wallet type—custodial or non-custodial—you should use. Custodial wallets are a convenient choice for individuals looking for an easy-to-use access point. Non-custodial wallets, on the other hand, enable you to be your own bank in the fascinating world of cryptocurrencies if security and total control are your top priorities.
 

  Hot wallet Cold wallet Custodial wallet Non-custodial wallet
Pros Convenient access from anywhere. Highly secure, offline storage. User-friendly, easy access. User-controlled, enhanced security.
  Instant transactions. Protection against hacking. Custodian support for backup. Full control over funds.
  Integration with various platforms. High level of privacy. Customer support. Privacy and anonymity.
Cons Vulnerable to hacking. Requires physical access. Reliance on custodian's security. Risk of losing access.
  Susceptible to phishing attacks. Not convenient for regular transactions. Lack of full control. Responsibility for security.
  Potential loss of funds. Possibility of loss due to damage or loss of device. Privacy concerns. Complexity for new users.

Why Crypto Wallets Are Important

Examples of crypto wallets

Most common examples of cold crypto wallets include:

  • Ledger provides multiple wallet options, such as the Nano S and Nano X devices 
  • Trezor provides the beginner-friendly Trezor Model One and the pro Trezor Model T hardware crypto wallets
  • SecuX has a robust portfolio of hardware wallets, involving the V20, W20 and W10 device
  • SafePal offers S1 hardware wallet as a cost-effective option

When it comes to the types of hot wallets, the best examples are:

  • Coinbase, which has three variants of crypto wallets, online, desktop, and mobile
  • Exodus, which offers desktop and mobile cryptocurrency wallets and is also compatible with the Trezor wallet
  • Crypto.com features different services within its exchange, such as a crypto wallet with a web-based model and a mobile app
  • MetaMask comes with a mobile app, and a desktop wallet that represents the Firefox extension
  • Trust Wallet comes with a mobile cryptocurrency wallet option and is compatible with NFTs

Frequently Asked Questions

What are the different types of crypto wallets?

There are several different types of crypto wallets available in the market today. The most common ones include hardware wallets, software wallets, and paper wallets.

How do I choose the right crypto wallet for me?

Determine your preferred level of security. Hardware wallets provide the highest level of security as they store your private keys offline, while software wallets offer convenience but may be more susceptible to hacking. Secondly, consider the type of cryptocurrencies you plan to store. Some wallets support a wide range of cryptocurrencies, while others are more limited in their compatibility. Additionally, it's important to research the reputation and track record of the wallet provider to ensure they have a strong history of security and user satisfaction. 

How to protect your crypto wallet from hacking?

Opt for a hardware wallet rather than a software-based one, as it provides an additional layer of protection by keeping your private keys offline. Secondly, enable two-factor authentication (2FA) on your wallet, which adds an extra level of security by requiring a second verification step. Additionally, regularly update your wallet's software to benefit from the latest security patches and features.

Written by

Brian is a freelance writer, author, investor, and market commentator. He has been studying the technology of Bitcoin since 2013 and writing about cryptocurrency and crypto investing since 2017. Brian has interviewed and written about many top leaders in the Bitcoin and blockchain space. His journalism and commentary have been featured in MSN Money, Cointelegraph, SoFi, Robinhood, BitPay, Blockworks, Business Insider, and The Balance. He has helped tech and finance startups increase their reach, build their brands, and gain subscribers. He has a passion for Bitcoin and for educating others through engaging content, helping them to improve their financial situations as much as possible. In addition to his journalism, he has written white papers for Bitcoin start-ups, and contributed to the Nicoya Research investment newsletters.