What is a Crypto Wallet?

Cindicator Team -

Discover what exactly a crypto wallet is and why someone should have one.

Safe storage of cryptocurrency is extremely relevant in 2023. More and more users buy, sell and exchange crypto assets on a daily basis. Accordingly, multiple new crypto wallets appear each year, making it difficult to choose a worthwhile project.

There are several types of wallets which each have their own set of tasks and principles of work. This article will help you learn more about the variety of crypto wallets and their operational principles.

What does a crypto wallet do?

A cryptocurrency wallet is a piece of software, or application for storing, exchanging, sending, and receiving cryptocurrency or various digital assets. Such services are similar to online banking but in the blockchain sphere. Crypto wallets are available as physical USB-like devices like Ledger (cold wallets) and in an online format like Metamask (hot wallets).

Each cryptocurrency wallet can store many different assets if the developers have provided a connection to different blockchains. Some cryptocurrencies are designed for a single blockchain — for example, Bitcoin or Ethereum.

However, before choosing one or another crypto wallet, you should understand the the inner workings in more detail.

How do crypto wallets work?

A traditional Bitcoin wallet has three elements: a public key, a private key, and a SEED phrase.

  • The public key is your coordinate (address) in the blockchain. Anyone can see it. It is used to make a deposit or exchange as a user identifier.
  • The private key is a unique password. You will need to enter it when transferring or exchanging cryptocurrencies. A private key has a similar use-case to a credit card password.
  • SEED-phrase is an auxiliary sequence of 12-24 randomly ordered words. It is used when you need to recover a private key, for example, if you have lost or forgotten it.

However, most hot wallets simplify the interaction for the user. Therefore, to work with crypto transactions, you only need to know the address of the asset and the SEED phrase to authorize or restore access to the wallet.

Step-by-Step Process of How a Crypto Wallet Works:

  • Step 1: Creating a Wallet – When you create a crypto wallet, the software generates a pair of cryptographic keys: a public key and a private key.
  • Step 2: Receiving Funds – You can share your public key with others to receive cryptocurrency, such as Bitcoin or Ethereum. The sender uses your public key (your wallet address) to transfer funds.
  • Step 3: Storing Cryptocurrency – The wallet tracks your balance on the blockchain using your public key. However, the actual cryptocurrency remains on the blockchain, not inside the wallet itself.
  • Step 4: Sending Funds – To send cryptocurrency, you must use your private key to sign the transaction, verifying that you are the rightful owner of the funds.
  • Step 5: Confirmation on the Blockchain – The transaction is then broadcast to the blockchain, where it is validated by miners or validators, depending on the cryptocurrency’s consensus mechanism (e.g., Bitcoin’s proof-of-work or Ethereum’s proof-of-stake).

What is a Crypto Wallet Used For?

Crypto wallets are essential for interacting with the blockchain ecosystem. They serve several critical purposes:

1. Storing Cryptocurrency

The primary use of a crypto wallet is to store your private keys, which give you access to your digital assets on the blockchain. Whether you're holding Bitcoin, Ethereum, or other digital currencies, a wallet keeps your access keys safe and secure.

2. Sending and Receiving Cryptocurrency

With a crypto wallet, you can easily send and receive cryptocurrency. By using your public key, others can transfer funds to your wallet, while your private key allows you to send Bitcoin, Ethereum, or any other cryptocurrency to others.

3. Managing Multiple Cryptocurrencies

Most wallets allow users to store and manage multiple types of cryptocurrencies. This flexibility makes crypto wallets an essential tool for investors and traders who want to manage a diverse portfolio, such as Bitcoin, Ethereum, Litecoin, and other altcoins.

4. Engaging in DeFi and dApps

Crypto wallets also enable users to engage in decentralized finance (DeFi) protocols and decentralized applications (dApps). For example, with wallets like MetaMask, users can connect directly to DeFi protocols on the Ethereum network to trade assets, lend or borrow cryptocurrency, and participate in yield farming, all without the need for an intermediary.

5. Secure Transactions

Because crypto wallets are encrypted and require private keys for authorization, they offer a higher level of security for transactions compared to traditional banking systems. The decentralized nature of blockchain, especially networks like Bitcoin and Ethereum, further enhances the security of your digital assets.

What is a Crypto Wallet for Beginners?

For beginners, the concept of a crypto wallet might seem intimidating, but it’s not as complex as it first appears. There are two main types of crypto wallets you should be aware of:

1. Hot Wallets (Software Wallets)

Hot wallets are software-based wallets that are connected to the internet. These are typically easy to use, making them ideal for beginners. Examples of hot wallets include:

  • Mobile Wallets: Apps you install on your smartphone, such as Trust Wallet (supports Bitcoin, Ethereum, and other currencies) or Coinbase Wallet.
  • Desktop Wallets: Applications you download and run on your computer, like Exodus or Electrum (commonly used for Bitcoin).
  • Web Wallets: Wallets that operate through a browser interface, like MetaMask (often used for Ethereum) or MyEtherWallet (MEW).

Pros of Hot Wallets:

  • Easy to set up and use.
  • Convenient for frequent transactions.
  • Often free to use.

Cons of Hot Wallets:

  • Vulnerable to hacking because they are always connected to the internet.
  • Less secure for storing large amounts of cryptocurrency.

2. Cold Wallets (Hardware or Paper Wallets)

Cold wallets are offline wallets that store your private keys offline, making them more secure from hacks and malware. Examples of cold wallets include:

  • Hardware Wallets: Physical devices like the Ledger Nano S or Trezor that securely store your private keys for assets like Bitcoin, Ethereum, and other cryptocurrencies.
  • Paper Wallets: A physical document that contains your public and private keys, usually in the form of QR codes.

Pros of Cold Wallets:

  • More secure than hot wallets, as they are offline.
  • Ideal for storing large amounts of cryptocurrency (like long-term Bitcoin or Ethereum investments) over long periods.

Cons of Cold Wallets:

  • Less convenient for quick transactions.
  • Typically, there’s a learning curve to set them up.
  • Hardware wallets often come with a cost.

Custodial and non-custodial crypto wallets

Cryptocurrency wallets are also divided into custodial and non-custodial, depending on the involvement of a third party in asset transactions.

A custodial wallet is a wallet in which personal data is stored by the operator (custodian). It has its own advantages – for example, in the case of a lost password, the user will still be able to restore access to their funds.

Many cryptocurrency exchanges (Coinbase, Binance, etc.) and brokerage services utilize custodial wallets. Such integration simplifies the work with other tools of these platforms and is beneficial for transactions.

Custodial wallets are optimal for speculative trading, as exchanges provide additional financial services such as interest-bearing deposits, futures, lunch pools (platforms that allow earning new tokens), etc.

A non-custodial wallet gives the user complete control over the keys and funds. Decentralized exchanges and special services create such wallets — for example, wallets like ZenGo and Nuri.

Non-custodial wallets can also be created in particular browser extensions (MetaMask). After a simple registration procedure, such extensions provide an address and a private key. A hardware wallet is also considered non-custodial. Accordingly, such solutions are suitable for long-term investments and asset storage because they provide a high level of security.

However, non-custodial wallets also have disadvantages. If the private key and the phrase to recover it are lost, funds will be irretrievably lost. Such wallets can also be affected by a hacker attack.

To receive funds to such a wallet, you need to give the sender a public key. To send cryptocurrency, you must enter a private key into a software wallet and create a transaction. The use of QR codes simplifies both these actions.

How to choose a wallet

When investing in crypto, you must choose at least one type of wallet to store them in. For example, institutional investors are more likely to use hardware wallets to store large amounts of cryptocurrency. It is safer but creates minor inconvenience.

Hot wallets are more popular among crypto-enthusiasts, but you always have to consider the security and the need to diversify assets to keep them protected.

Feel free to experiment with different wallets to see how you like them and to figure out how they work. Using smaller amounts of crypto (< $100) at first is great for experimenting and seeing how you like each user interface.

Conclusion

The choice of crypto wallet depends on your objectives, the number of assets you possess, and the purpose of use. If you want maximum reliability, then choose hardware options in the form of USB devices.

If speed and availability are essential to you, then look for options with a positive reputation on the market among “easy” hot wallets like Trust or Metamask.

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Author:
Ken Melendez
✍️ Head of Content @ Cindicator
📊 Certified Bitcoin Professional
🔐 Blockchain Chamber - Chapter President

Who is Cindicator?

Cindicator is a world-wide team of individuals with expertise in math, data science, quant trading, and finances, working together with one collective mind. Founded in 2015, Cindicator builds predictive analytics by merging collective intelligence and machine learning models. Stoic AI is the company’s flagship product that offers automated trading strategies for cryptocurrency investors. Join us on Telegram or Twitter to stay in touch.

Disclaimer

Information in the article does not, nor does it purport to, constitute any form of professional investment advice, recommendation, or independent analysis.