What is a Cryptocurrency Wallet? A Beginner’s Guide

Wallets ... the door to Web 3.0

This is a beginner's guide to cryptocurrency wallets in 2023

So if you want to learn:

1. What is a cryptocurrency wallet

2. How a cryptocurrency wallet works, what types are there

3. How to set up a cryptocurrency wallet

Let's dive right in.

CONTENTS:

  1. What is a cryptocurrency wallet?
  2. Understanding Cryptocurrency Wallets
  3. How to set up a cryptocurrency wallet?
  4. FAQs


1. What is a Cryptocurrency Wallet?

Satoshi Nakamoto introduced the first cryptocurrency wallet, the Bitcoin-Qt wallet when he first released Bitcoin in 2009. Despite its limitations, the Bitcoin-Qt wallet allowed to send, receive, and digitally sign transactions. 

Nowadays, the cryptocurrency wallet market provides a diverse selection of wallets. From hot/software wallets hosted directly on an exchange (custodial) to web, mobile, and desktop wallets that give the owner complete control over their private keys (non-custodial) to cold wallets that offer cutting-edge security by keeping your keys offline (hardware wallets) or even disaster-proof like metal/steel wallets.

But how does a cryptocurrency wallet work? Crypto wallets use cryptography to secure access to any cryptocurrency you own (public-key cryptography). They employ asymmetric encryption (public and private keys) and “trapdoor functions,” which are one-way mathematical functions that are nearly impossible to reverse.

Public keys function similarly to your bank account number and are used to receive cryptocurrency, whereas private keys work similarly to your password or PIN which allows you to send and withdraw cryptocurrencies. Private keys should always be kept private.

Consider a wallet similar to an online banking app, instead of providing access to a central ledger (bank) that stores all your data, provides access to a distributed ledger (blockchain) that manages data and transactions in a decentralized manner. A wallet contains the necessary information (address and digital keys) to access your funds.

Before selecting a cryptocurrency wallet, you might consider your short- and long-term goals, as well as the security, reputation, fees, access to private keys (custodial and non-custodial), cryptocurrency support, customer care, backup capabilities, and convenience that a wallet provider offer.

Keep reading to find out more!


2. Understanding Cryptocurrency Wallets

Satoshi Nakamoto introduced the first crypto wallet, the Bitcoin-Qt wallet, when he first released Bitcoin in 2009. Because the Bitcoin-Qt wallet was a full client, you had to download the entire blockchain history for it to sync. This wasn’t a concern at first, but as the blockchain grew in size, the synchronization interval grew longer and longer, eventually taking days. 

Despite its limited capabilities, the Qt wallet allowed the user to send and receive funds, as well as incorporate an address book. It also allowed the user to digitally sign a transaction, proving that they were the owner of a specific public key.

Nowadays, the market of crypto wallets has exploded, providing a plethora of possibilities which we will explore in the following article. 

How do cryptocurrency wallets work?

The first thing we need to know is how cryptocurrency wallets work. Crypto wallets rely on cryptography to secure access to any cryptocurrency you own. It is important to note that a crypto wallet does not contain any actual cryptocurrency. A blockchain (or DLT) is used to store the cryptocurrency itself. Wallets serve as a gateway. 

To be more specific, they use public-key cryptography (PKC), which is a method of validating the authenticity of something through the use of asymmetric encryption (a public and a private key). PKC was initially used to encrypt and decrypt messages.

Cryptocurrencies adapt this technology to encrypt and decrypt transactions. The secret of PKC is “trapdoor functions,” which are one-way mathematical functions that are easy to solve in one direction but nearly impossible to break in the opposite direction (To reverse engineer these functions, you need a supercomputer and thousands of years).

In general, crypto wallets use two types of keys: public keys and private keys.

  • Public Keys: You can receive cryptocurrency transactions if you have a public key. It is a cryptographic code that is associated with a private key. It works in the same way as your bank account number does. You can share your public key with anyone, but you’ll need a private key (PIN) to unlock it and show you’re the owner

    • Wallet Address: To be more precise, the public key you show anyone is a compressed and shorter form of your public key in order to make crypto sending easier. Wallet addresses are often in one of two formats: a long string of alphanumeric numbers or a scanned QR code.
    • Encrypting & verifying: A public key is also used to encrypt messages and transactions when sending cryptocurrencies and verify the authenticity of the sender when receiving crypto. 

  • Private Keys: If you have a private key, you can access funds (on the blockchain), send and withdraw cryptocurrency, and retrieve your public keys. Private keys are the most critical part of a cryptocurrency wallet and should always be kept private. It functions similarly to your bank account login information or a card verification value (CVV) on the back of your card.

    • Digital Signature: We use private keys to sign transactions and prove ownership of funds. Consider how, when you send a transaction, the bank requests your PIN to confirm it.
    • Decryption: For every private key there is a unique public key (or address). With the right pair of keys, we can decrypt the message that comes from its correspondent public key.

  • Seed Phrases: The majority of current wallets also use seed phrases, which can be used to generate multiple private keys (Root Key). It is essentially a set of words to access your cryptocurrency wallet. It functions similarly to your bank account’s security recovery phrase. Seed phrases make it easy for users to back up their wallets. 

Let us use an analogy (traditional banking) to help my grandmother comprehend. 

Assume I wish to send 0.0023 BTC (100 USD in January 2022) to my grandmother

Please keep in mind that this is an oversimplification of cryptography. The following explanation may make some cryptography specialists cringe.

Purpose: Send 100 USD worth of Bitcoin (0.0023) to my grandmother

Step 1

  • Traditional Banking: Login into your mobile banking application. To log in you need a PIN or password. With the PIN we sign/authorize a transaction.
  • Crypto Technology: A PIN or password is also required to access your wallet “application.” In reality, this is a human-rememberable password used to generate a private key. With the private key, we sign/authorize a transaction. 

Step 2

  • Traditional Banking: Input your grandmother’s bank account. 
  • Crypto Technology: Input your grandmother’s wallet address (derived from the public key). We encrypt the transaction with our grandmother’s public key so that it can only be decrypted with our grandmother’s correspondent private key.

Step 3 – This is the primary distinction between traditional banking and cryptocurrency

  • Centralized Ledger (Bank): Our bank processes the transaction
  • Distributed Ledger (DLT/Blockchain): It is Blockchain technology that handles our transaction in a decentralized manner, eliminating the need for a third party.

Step 4

  • Traditional banking: In traditional banking, our grandmother can access her bank account using her login details or password. 
  • Crypto technology: In crypto, our grandmother accesses her wallet using her password (which is derived from her private key). Furthermore, using Marc’s public key, his grandma can confirm that Marc, not his brother, sent the transaction.

Types of cryptocurrency wallets 

There are various types of cryptocurrency wallets. We categorize them as “hot” and “cold.”

Hot Wallets: Any wallet that is connected to the internet is considered a hot wallet. These are also known as Software Wallets. This is the most practical option for traders and frequent users. 

  • Custodial (exchange wallets): These wallets are “hosted” directly on the exchange (Binance, Kucoin, Coinbase, etc) where you buy and sell your cryptocurrency. In a custodial wallet, you entrust your private key to a third party who holds it on your behalf. This is the most vulnerable, but also the most convenient and beginner-friendly. Technically, these are also web wallets. 
  • Non-custodial: You are the owner of your private keys.

    • Web Wallets: We use an online browser interface to access the blockchain/DLT without having to download or install anything. Popular web wallets are Metamask, Brave, Binance chain wallet, Phantom etc. 
    • Desktop Wallets: Desktop wallets are pieces of software you download on your computer and execute locally. There are considered safer than web wallets but you need to ensure your computer is clean of viruses. Popular desktop wallets are Electrum, Exodus, Atomic Wallet, etc.
    • Mobile Wallets: Mobile wallets are similar to desktop wallets but they work as applications on your smartphone. They usually use QR codes for convenience. Popular mobile wallets are Edge, Electrum, Mycelium, etc. 

Cold Wallets: A cold wallet is a physical device or object that does not have an internet connection. A cold wallet stores the keys offline. This is a more secure option for storing your “coins” and protecting them from hacker attempts. This is the most convenient option for long-term holders. 

  • Hardware Wallets: Physical or electronic devices that generate public and private keys using a random number generator (RNG). The keys are kept on a device that is not linked to the internet. Popular hardware wallets are Ledger and Trezor.

    • Steel/Metal Wallets: Steel/Metal wallets are the most secure type of hardware wallets. They have extra layers of security to store your seed phrases and are fireproof, acid-resistant, corrosion-resistant, and virtually uncrushable. Popular steel/metal wallets are CryptoSteel Capsule, Billfodl, etc. 
  • Paper Wallets: A paper wallet is a piece of paper on which a crypto address and associated private key are physically printed as QR codes. These codes are then scanned in order to carry out transactions. This method of cold storage is considered obsolete. 

    • Pen & Paper: Classic pen & paper is also a form of cold storage. Write down your public and private keys and store them in a safe location. 

How to choose the best cryptocurrency wallet? 

The best crypto wallet for you will depend on your level of experience, as well as your knowledge and prior experience with cryptocurrencies. 

The first thing we need to know is the problem we want to solve. Ask yourself: 

  • Do I want a wallet for short or long-term purposes? If you plan to use the wallet frequently then a hot wallet is more suitable than a cold wallet. 
  • What is my level of cryptocurrency experience? (from 1 to 5)? If you are a beginner, web wallets (custodian and non-custodian) are the best choice. 
  • How much money do I have in crypto? If you have a considerable amount of crypto, consider buying a hardware wallet to store your crypto securely. 
  • What cryptos am I planning to buy? Ensure your wallet supports those altcoins you want to purchase. 

A few areas to consider: 

  • Security: You should carefully consider the layers of security that wallets offer. Hackers have targeted custodial (exchange) wallets in particular. Make sure you use all of the regular security precautions to protect your account and private keys.
  • Reputation: The crypto world can be a wild west. The reputation of the wallet maker is an important factor to consider. Look for it on forums, as well as on the app store, google play, or Trust Pilot. 
  • Custodial or non-custodial: You theoretically do not have control over your crypto if you do not have access to your private keys. Check that your wallet allows you to access your private keys. Try not to keep all of your money in one place if you are a regular trader and need access to exchanges.
  • Fees: Transaction fees can be charged in a variety of ways. Look for a wallet with useful settings such as fast, medium, and slow. Some wallets are pre-configured to perform fast transactions (at a higher price), but you should be able to change your transaction fee.
  • Cryptocurrency support: Because not all wallets support all types of altcoins, make sure you purchase the correct wallet for your needs.
  • Customer support: Some companies offer 24/7 support and quick response times. Always keep an eye on the level of support you get.
  • Back up features: The best wallets offer key management features, also known as backup features to easily store and recover your private keys.
  • Convenience: Usually, there is a trade-off between convenience and security. If you frequently use a computer, hardware and desktop wallets may be the best option. Web and mobile wallets, on the other hand, may be more appropriate if you are more mobile.


3. How to set up a cryptocurrency wallet?

Consider crypto wallets to be a type of encrypted virtual key that contains all of the information required to access your funds on the DLT or blockchain. Your address (es) as well as your digital key are generated, combined, and stored in a wallet (s)

Here are the general steps to set up a crypto wallet: 

  • Step 1: Choose the best type of wallet for your needs. Hot wallets are ideal for traders and regular users. Cold wallets are ideal for long-term investors and those who have a significant portion of their capital in cryptocurrency
  • Step 2: Buy or download your wallet (or wallet extension)
  • Step 3: Install the software 
  • Step 4: Set up account and security measures. Keep your private and seed phrases safe at all times. If required, write them down on a piece of paper.
  • Step 5: Deposit your altcoins

If you follow these steps correctly, your altcoins will be safe and sound.


4. FAQs

What cryptocurrencies can I keep in my cryptocurrency wallet?

Wallets typically do not support all altcoins or cryptos. There is currently no wallet that can support ALL of the cryptocurrencies available on the market. However, there are many multi-currency wallets that support most of them. Ledger, Coinomy, Trezor Exodus, Trust Wallet are multi-coin wallets while others like MetaMask are primarily used for Ethereum and Ethereum tokens.

How do I back up my cryptocurrency wallet?

Online banking uses a security phrase that can be used to reactivate your account. Crypto wallets use 12-24 word phrases (seed phrases) instead. The procedure will alter depending on the software you select, but the essential functionalities are the same. It is good practice to back up your wallet against any software bugs that may arise.

What is a cryptocurrency wallet app?

Mobile wallets (crypto wallet apps), like mobile banking apps, are accessible on the App or Google Play store. The private keys required to access your funds are stored in the app (wallet). To access your wallet, you can use any portable device, such as a smartphone or tablet. Mobile wallets are ideal for people who are always on the go.

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AUTHOR

Marc Arbonés
Marc is a millennial economist, systems thinker, crypto investor (since 2017), crypto writer, and peak performance consultant. He is the Editor and Founder of Altcoins Mastery, where he seeks to onboard as many people as possible into a "fairer" financial system powered by Crypto, DeFi, and web 3.0.