For many cryptocurrencies, like Bitcoin and Ethereum, you’ll need a “wallet” to use the currency. You can think of a wallet like a bank account. You can use it to send, receive and store your currencies.
Unlike a real life wallet, where you carry your credit cards and bank notes, your cryptocurrency wallet doesn’t actually contain any actual cryptocurrency. Your wallet simply contains the digitally keys needed to access your currency and to sign transactions.
How wallets work under the hood
Your cryptocurrency wallet contains two main components. They contain a public key and a private key. The public key is your wallet’s address. If anyone wants to send you some Bitcoin, they send it to this address. The private key is used to mathematically “sign” transactions, so that the network knows that a transaction is legitimately from you.
When you create a new wallet, what you’re doing is creating a private key that is mathematically linked to your public wallet address. You can share your public wallet address with the whole world. Your private key you NEVER share with anyone. Anyone with your private key has access to your wallet. Your wallet doesn’t hold any cryptocurrency. It holds the private key.
For example, Bitcoin transactions are posted on a public ledger. When you send a Bitcoin transaction from one Bitcoin address to another, no physical Bitcoin is actually moved. Instead what you’re doing is broadcasting this transaction to the entire Bitcoin network. Everyone on the network updates their copy of the public ledger to reflect the fact that there is a decrease in Bitcoin from one account and an increase in another. Your Bitcoin wallet contains the mathematical proof that confirms to the public ledger that a transaction is really from you.
Types of Wallets
There are a number of different types of cryptocurrency wallets. But generally they fall into four categories.
- Software wallets – With software wallets, you install software onto your computer or mobile device. You have complete control over the private keys. With software wallets, you have complete control of your funds but require some technical knowledge to properly setup.
- Hosted Wallets – Hosted wallets are wallets that are hosted by a trusted 3rd The 3rd party takes care of all technical aspects of managing the private keys. To access your funds, you use a username and password to login to the hosted wallet. For most people with a small amount of cryptocurrency, and who are new to cryptocurrencies, we recommend using a trusted hosted wallet like Coinbase.
- Hardware Wallets – Hardware wallets are a type of “cold storage” wallet. Cold storage means that your bitcoin is stored offline, not connected to the internet. Hardware wallets store your private key on a secure physical device. The only function of a hardware wallet is to securely store the private key. This makes them immune to computer viruses and attacks from the internet. Be sure to only use a reputable hardware wallet like the Ledger Wallet.
- Paper Wallets – Paper wallets are another type of cold storage wallet. But unlike a hardware wallet, the data needed to generate the private key is stored on a physical document. Paper wallets are the cheapest way to store cryptocurrencies offline, but can also be very unsafe if not done properly.
In general, we recommend using cold storage wallets for storing any long term funds that you don’t anticipate using. And use a software or hosted wallet for funds that you want quick access to.
Wallet backup and security
When setting up a wallet, do your homework. Always be sure to only download wallet software from trusted sources. And only use reputable hosted wallet services like Coinbase. It’s also very important that you take steps to back up your wallets in case you lose access to them.
Learning how to use cryptocurrency wallets is important if you want to reap the benefits of owning and transacting in cryptocurrencies. Participating in the crypto economy is in effect learning how to be your own bank. With proper backups and security of your cryptocurrency wallets you can be assured that your funds are safe and in your own control.