We live in the digital age, so more and more people are using cryptocurrency to purchase goods and services online. To use cryptocurrencies for trade online, you would need a software program called cryptocurrency wallet. A cryptocurrency wallet allows you to receive and send digital currency or coin, as well as to monitor your transactions and your balance.
What are the different types of cryptocurrency wallets? There are two main types of cryptocurrency wallets based on your level of control over your digital funds: custodial and non-custodial. However, there are also different types of wallets based on access: Desktop, Online, Mobile, Hardware, and Paper.
If you are new to cryptocurrencies, equip yourself with all the knowledge you can get your hands on before you start doing any online transaction. There are several things you need to know, including how cryptocurrencies and digital wallets work. It will also help if you familiarize yourself with the many kinds of cryptocurrency wallets, how they differ from each other, and which one is best for you. (Register for a free forums account and join the discussion)
How Do Cryptocurrencies Work?
Cryptocurrency is a digital form of money that you can use to pay for goods and services or that you can trade for profit. Cryptocurrency is encrypted and runs on a monetary system that is not governed, tracked, or regulated by any formal institution or centralized authority.
There are many digital currencies now, and they perform various functions. A cryptocurrency or digital token that is issued by a particular company, for instance, can be exchanged for goods and services provided by that company. (See How to Spend Cryptocurrency.)
Each cryptocurrency works through a technology that manages and records transactions. This technology is called blockchain, and it is spread across a network of computers. Blockchain ensures that a cryptocurrency is tracked as well as secure.
Elements of Cryptocurrency
Cryptocurrency is different from traditional forms of currency because of these elements:
1. Cryptographic. Cryptocurrency uses encryption, which is a system of cryptography, to keep track of the creation of coins and to verify transactions.
2. Decentralized. A centralized government controls and oversees most traditional currencies in circulation, and a third party regulates the creation of these currencies. With cryptocurrency, no single entity affects it. The creation and transactions are controlled by code and are open-source, and it relies on peer-to-peer networks.
3. Adaptive scaling. Cryptocurrencies are created with certain measures to ensure that they will work well regardless of whether they are small-scale or large-scale.
4. Open Source. Cryptocurrencies are open source. This means that developers can create APIs or application programming interfaces without having to pay a fee. It also means that anybody can join and use the network.
5. Digital. Traditional currencies are defined by a physical object, like gold coins or paper bills. With cryptocurrency, however, no physical object exists, and it is all digital. These digital coins are kept in encrypted digital wallets and are digitally transferred to another person’s digital wallet.
6. Proof-of-work System. Most cryptocurrencies use a proof-of-work scheme, which uses a computational puzzle to limit the abuse of cryptocurrency mining. This computational puzzle is hard to compute but easy to verify. In other words, the proof-of-work system is the concept of work giving value to a cryptocurrency. Another method for validating or giving value to coins is called proof-of-stake.
7. Value. Cryptocurrency has to have value to be useful and effective. Digital coins are generated by “miners,” who run programs on special hardware that is specifically made to solve proof-of-work computational puzzles. Their mining efforts are what give the coins’ value. The scarcity of these coins, as well as the demand for them, is what makes their value fluctuate. Value comes from factors like supply and demand and utility.
8. Pseudonymity. Digital coin holders can keep their coins in a digital wallet. Your identification is stored in an encrypted address that is not attached to your identity. This connection between you and your digital coins is pseudonymous, not anonymous since ledgers are accessible to the public.
What is a Cryptocurrency Wallet?
Cryptocurrency wallets are secure digital wallets that allow you to transact using your digital coins or tokens. They are software programs that store your private and public address keys and interface with blockchains so you can monitor your balance, send money, and do other transactions pertaining to your digital coins.
A cryptocurrency wallet is essentially like your bank’s online account platform, wherein your private address key functions like your bank account number, and the blockchain is like your bank’s ledger.
Simply put, you use your cryptocurrency wallet to receive, “store,” and send digital currency like Bitcoin, Ethereum, Ripple, Libra, EOS, and Litecoin. Most digital coins have their official wallet.
Wait, Wallets Don’t Actually Store Your Digital Coins?
Your cryptocurrency wallet does not actually store your coins. A coin is instead stored on the blockchain, and a wallet is designed to interact with this blockchain.
Instead of storing your coins, your wallet stores addresses or keys.
How Does a Cryptocurrency Wallet Work?
When another person sends you digital coins, they are signing off ownership of these coins to your digital wallet’s private address. For you to unlock the funds sent to you and for you to be able to spend these funds, the private key that is stored in your wallet needs to match the public address assigned to the currency.
If these two keys fit together, your digital wallet balance will increase, and the balance of your sender will be deducted. There is no real exchange of coins. The only thing that signifies the transaction is a record on the blockchain and a change in your digital wallet’s balance.
What is a Public Address?
A public address is like account numbers that are specific to a cryptocurrency. You can use it to receive a specific type of cryptocurrency. For instance, you would need a Bitcoin address to receive Bitcoin. A public address can be shared publicly.
Each address traces back to all the transactions that are associated with a coin’s blockchain. And your wallet will let you see the balances that are associated with an address and will let you move the coins around on the blockchain provided that you own this address.
And to prove that you own this address, you need a private key.
What is a Private Address?
A private address or a private key is a secret code that is associated with a public address. There are types of wallets wherein a custodian or a third party holds this key for you, and all you need is a wallet password to access this private key.
Single-Use or Multi-Currency?
There are a few types of digital wallets, each a little bit different from the others. However, in general, a particular wallet will work with one or more cryptocurrencies. It will also be able to store one or more public addresses that are specific to a cryptocurrency. In other words, some wallets are designed for one specific cryptocurrency, while others are built to be used for several digital currencies.
So, if you are interested in using multiple cryptocurrencies, you would not need to get a separate wallet for each one. Instead of setting up a digital wallet that supports only a single currency, getting a multi-currency wallet would be more convenient.
Custodial Wallet vs. Non-Custodial Wallet
There are two basic types of digital wallets: custodial and non-custodial. These two categories are based on the level of control you have over your funds. (Reference)
A custodial wallet is a type of cryptocurrency wallet that keeps your private keys and provides security and backup for your digital coins. Custodials will provide you with the most convenient way to store encryption codes. This type of wallet is best for users who want secure solutions that are user-friendly, and that give them access to their cryptocurrency at the touch of a button.
A non-custodial or light wallet, on the other hand, is a type of digital wallet that is decentralized, where you own your private keys. You get a file with your private keys, and you would need to write them down or use a mnemonic phrase that you can use to restore your funds. This means that you have full control over your funds.
With custodial wallets, you depend on the custodian’s security measures to keep your digital assets safe. Exchanges, for instance, use this common technique wherein they keep a portion of your funds in cold storage and allow some of these funds to be available online. The problem with exchanges is that they are high-profile hacking targets, and there won’t be much you can do once your funds are stolen.
In terms of you losing access to your account, like losing your password, exchanges are expected to put in place certain mechanisms so you could regain access.
With non-custodial wallets, you are given full control over your digital assets, and the safety of your funds is solely your responsibility. Also, you alone can decide what to do with your funds. Another good thing is that you are often provided serverless solutions and your private addresses are stored in an encrypted format on your device.
Your funds are safe as long as you make sure that you set up your wallet in a manner that it would require a password to open it. You also need to make sure that your wallet auto-locks quickly. Most importantly, you should never share your wallet’s login details with anyone.
Which is More Secure?
Non-custodial wallets are clearly safer than custodial wallets. However, in the event that you lose your device or forget the password to your wallet, the only way to recover the funds is with the seed phrase that was given to you when you set up your wallet the first time. This phrase consists of 12 words that you need to remember or write down. If you lose this seed phrase for some reason, you wouldn’t be able to recover your wallet and your funds at all.
Custodial wallets can integrate more customer service into their product, which makes it easier for you to use. You can install a mobile wallet app on your smartphone, for example, and if you lose your phone, you can download the wallet app again, install it on your new device, and access it using your account details.
What makes this possible is the fact that your funds are with the company that developed the app, and all you need is to log in to access your account.
A non-custodial mobile wallet, on the other hand, won’t be as easy to restore. You would need the seed phrase that serves as your security code.
However, a non-custodial wallet is the better choice if you are planning to use your funds for occasional purchases and payments. Because you keep your money with you, you can make transactions whenever you need to.
I have found for my needs, a hardware wallet provides the proper balance of protection and security with ease of use. However, you do have to understand how to create addresses, send and receive currency, and choose safe multi-phrase passwords and keys. Others may find a different “sweet spot” as Andreas Antonopoulos discusses in this video:
Custodial Wallets: Benefits
Here is a more definite list of the benefits of using custodial wallets:
1. Instant and free transactions. When you send funds through the blockchain, you would have to pay a processing fee. The more you pay for this, the faster the transaction goes through. With some custodial wallets, however, you will be able to transact or send funds for free if it is within their ecosystem.
Additionally, you can manage your digital coins quickly and do it at any time as long as there is an Internet connection.
2. Lost private keys are not equal to lost funds. Even if you lose your phone or laptop, you can still recover your wallet account and funds. You don’t need to bother with a seed phrase or a mnemonic phrase at all. The third-party company or custodian already has your account backed up and you can easily retrieve this through e-mail.
3. Custodial wallets can back you up. As in any technology, a simple mistake in blockchain can spell trouble. The good news is that with custodials, you can still retrieve your funds even if some things went wrong, like your transaction failed or your transaction did not reflect in your account balance.
Custodial Wallets: Disadvantages
Here are the disadvantages of using custodial wallets:
1. The custodian has control over your money. A custodial wallet functions the same way as a bank. This means that you do not fully control your funds that are inside of this custodial system and are in the hands of another company even if your money remains essentially yours.
2. Your digital coins can be seized via court decisions. If you become a subject of a legal battle involving your assets, a court order might seize your digital funds from you.
3. Data breach threats. Custodial wallets may be vulnerable to security and data breaches. You may lose your funds and not be able to retrieve them if your cryptocurrency wallet gets hacked or compromised.
4. No offline facility. An internet connection is necessary to log in to your custodial wallet and do a transaction.
4. The transaction is not reflected on the blockchain in real-time.
Non-Custodial Wallets: Benefits
What are the advantages of using non-custodial wallets? Here’s a quick rundown:
1. You have full control over your digital funds. Non-custodial wallets provide you with individual access to your funds. You don’t have to look up to or rely on any third party to manage your digital coins and to perform any transaction related to your funds.
2. Your funds are more secure. As discussed above, your funds are in a much safer place because there is a lower risk of data or security breach in non-custodial wallets. Your funds are not in cold storage, all your data are with you, and you are in charge of all safety measures for your account. Therefore, you are not much of a target by hackers or phishers.
3. You can make withdrawals instantly. Non-custodial wallets do not need confirmation from a third-party player to perform a transaction. As such, the whole process is streamlined and you can withdraw funds instantly and without hassles.
4. The transaction is reflected on the blockchain in real-time.
5. Internet connectivity is not required to enjoy the services of non-custodial wallets.
Non-Custodial Wallets: Disadvantages
Non-custodial wallets have their limitations. What are these?
1. You will have to store your key properly. You are required to write down your seed phrase and keep it in a secure location that you are not likely to forget about. This is to ensure that you will be able to retrieve your account and your funds in case you forget your password or in case you lose your device.
2. Lost funds are irretrievable. Losing your private key or mnemonic/seed phrase means losing access to your wallet forever. There is no backup, and recovery is not possible.
Different Types of Cryptocurrency Wallets
There are also different categories of digital wallets based on where you access them. These are:
This type of digital wallet is downloaded and installed on a laptop or personal computer. These wallets can only be accessed from a single computer. This type of cryptocurrency wallet offers a high level of security unless your computer gets a virus or is hacked.
Online wallets run on the cloud, and you can access them from any device, wherever you are in the world. They are, therefore, very convenient to access. However, because a third party controls cloud services, your data and your private keys may be vulnerable to theft and hacking attacks.
Mobile wallets run on a smartphone application and can be used anywhere you are. You can be on a retail store and pay for your purchases with your digital coins if they’re accepted. Mobile wallets are also smaller in file size and simpler to navigate than desktop wallets.
Hardware wallets are wallets run on dedicated hardware specifically designed to hold cryptocurrencies and keep them secure. They are physical devices like flash drives or USB that don’t require access to the Internet. They are, therefore, considered to be the most secure digital currency storage solution.
Paper wallets refer to physical copies or printouts of your private and public address keys. They may also refer to a piece of software used to generate a pair of keys securely. You can also print these keys in QR code format. This type of wallet is easy to use and is highly secure because you can avoid storing data digitally.
Do Cryptocurrency Wallets Collect Transaction Fees?
You may have to pay minor processing fees for certain types of cryptocurrency transactions to network miners. However, for some transactions, you do not need to pay any fees at all. It is also possible for you to set your fee.
To give you an idea, though, the median transaction size of 226 bytes would require a payment of 18,080 satoshis or $0.12. A satoshi, named after original Bitcoin creator Satoshi Nakamoto, is the smallest unit of bitcoin recorded on the blockchain.
There are also some cases wherein, if you choose to set a low processing fee, your transaction may be placed on low priority. As such, you might have to wait for some time, perhaps hours or even days, before your transaction could get confirmed.
Therefore, If you need to complete your transaction and have it confirmed at the earliest possible time, you might need to pay a higher fee for it.
Whatever cryptocurrency wallet you use, transaction fees should not be a problem, and you shouldn’t worry about it. You will either pay minuscule transaction fees or get to dictate what fees you will be paying. Or, in some cases, you pay no fees at all.
What Makes a Good Cryptocurrency Wallet?
When looking for the best cryptocurrency wallet to use, you should look into these parameters:
- Ease of use
- Multi-currency support
- Look and feel
- Customer support
To be able to measure these parameters, ask the following questions, and get satisfactory answers for all of them:
- How secure is this cryptocurrency wallet?
- How much does this wallet cost? Does it collect transaction fees?
- Does this wallet have an easy to use interface? Is it intuitive?
- Does this digital wallet support multiple cryptocurrencies?
- Can I use this digital wallet anywhere? Is it easy to carry around?
- Does this wallet look nice? Does it feel old and clunky?
- How good is the customer support for this digital wallet company? Is everyone accommodating?
How Do You Make Your Cryptocurrency Wallet Secure?
Security is one of our top priorities when we enter the world of cryptocurrencies. As such, here are tips on how you can make your digital wallet and your funds secure:
1. Backup your digital wallet.
You should consider offline storage options for backup. Using paper and USB wallets on top of your online wallet is also great for protection against computer and web-related failures. They will also allow you to recover your wallet and your funds in case of device loss or theft.
Remember that using an online wallet is not 100 percent secure against eager hackers. The reality is, online wallets are inherently at risk, and you can’t always protect it.
2. Update your software.
Keep your digital wallet software updated so that you get to take advantage of the latest security improvements. Aside from updating your digital wallet software, you should also regularly update your computer or mobile software.
3. Add extra security layers.
The more security layers you add, the better for your peace of mind. For starters, you can set long and complex passwords that you should also remember or write down and keep in a secure place. Then you should ensure that any withdrawal of your funds would require a password.
4. Use credible cryptocurrency wallets.
Do some research on the best, most reliable, and highly rated cryptocurrency wallets available and weigh your options. Pick one that meets your requirements and best serves your needs. It should be one with a good reputation and also provides extra layers of security, such as additional pin code requirements and two-factor authentication every time you open a wallet application. You may also want a wallet that offers multi-signature transactions, wherein the permission of another user is required before a transaction is confirmed.
5. Don’t put all your funds in one.
It would be best if you store only small amounts of currency or coins for use every day, whether online, on your computer, or on your mobile app. A majority of your digital funds should be kept in a high-security location. In fact, as a rule of thumb, don’t keep more coins in your digital wallet than you would in your real one.
6. Keep your wallet passwords, PINS, and seed private. Never share your password, PIN, seed, or private key with anyone and make sure to store copies of them in a safe physical place. To transfer funds or send and receive coins, all you would need to share is your public address.