Cryptocurrency Wallets - Meaning and Different Types of Wallets
The ownership and storage of cryptocurrencies are quite different as compared to regular currencies. It is for this reason that people who are new to the crypto universe find it challenging to understand how the storage and transfer of cryptocurrency works. Cryptocurrency wallets are one of the most popular ways which are used to store cryptocurrency online. In this article, we will provide a simplified and de-jargonized way to understand the concept of cryptocurrency wallets as well as how they operate in day-to-day life.
What are Cryptocurrency Wallets?
Whenever an investor buys cryptocurrency, they get coins that are nothing but digital tokens. These digital tokens need to be stored at a safe secure place online. Some of these digital tokens are stored at the exchange itself. Centralized exchanges provide customers with such facilities. This means that the safety of the coins is managed by the exchange. However, it also means that the control of the coins is also passed on to the exchange. This increases the risk since there is always a chance of being locked out or the exchange being hacked.
How do Cryptocurrency Wallets Work?
Many new investors get confused with the concept of cryptocurrency wallets. They try to equate cryptocurrency wallets with bank accounts. However, there are a lot of differences. Bank accounts hold the money whereas cryptocurrency wallets do not actually hold any funds. Since cryptocurrencies follow the concept of a decentralized ledger, the money actually lives on the blockchain. However, in order to access the money, the ownership of the money has to be verified. This is done by using a key. These keys are stored in the wallet.
What are Public Keys and Private Keys?
Cryptocurrency wallets need two types of keys in order to function. They are called a public key and a private key. A public key is like the digital address for your wallet. This can be equated to a bank account number. Just like an investor gives out their bank account number in order to receive funds, similarly, the investor needs to give out their public key so that others can locate their digital wallet and transfer funds.
Transactions cannot be completed only by using a public key. The cryptocurrency system has been built in such a manner that a private key is required. This private key proves the ownership of an account. Only after the ownership has been authenticated can coins be sent or received from the wallet. These private keys are never on the blockchain since they are not supposed to be public information. Instead, these private keys are stored in the digital wallet.
Whenever a new digital wallet is generated, a recovery phase is also generated. This phrase is about twelve to twenty words long and can be used in order to reset passwords. Just like the private key, this information also needs to be stored safely.
Types of Cryptocurrency Wallets
Cryptocurrency wallets can be of various types. Some of the commonly used types have been listed below:
- Custodial wallets are when the control of the wallet is given to a third party. In these cases, the third party is in control of the private keys required to authenticate transactions. Many crypto exchanges provide custodial services. However, at the same time, there are many cryptocurrency wallets that specialize in only providing custodial services. The benefit of using this service is that the difficult part of maintaining the privacy of the system is outsourced. The drawback is an obvious loss of control which comes with outsourcing key tasks
- Non-custodial wallets are when the users are in charge of their private keys. The benefit is that they are in full control of their keys. However, the drawback is that there is a risk of losing the private key. This can be catastrophic since the private key is the only way to access the funds. In the absence of a private key, the investor would be locked out of their own funds. This has happened to many investors. There are people who have millions of dollars in their digital wallets but are not able to use the same they have forgotten their private key.
- Paper wallets are wallets wherein the key is written down on a piece of paper and stored in a secure location. The problem with this arrangement is that it is inconvenient. Cryptocurrency wallets are digital by their very nature. Accessing a piece of paper before conducting a digital transaction can be quite cumbersome.
- Hardware wallets are special devices that can be used to store private keys. They work like a USB. However, they are much more advanced when it comes to security. These devices are only connected to a computer when a person needs to conduct a cryptocurrency transaction.
- Online wallets are web-based portals where private keys are stored. These portals can be accessed with a two-step-based identification program. Online wallets are quite convenient in the sense that they can be used just like credit cards. Most investors prefer to use online wallets since they are safer and more convenient as compared to other mediums.
Hot Wallets vs. Cold Wallets
Cryptocurrency wallets can be classified using another classification. They can be classified as hot wallets or cold wallets based on whether or not they are connected to the internet.
Cryptocurrency wallets that are connected to the internet are called hot wallets. These wallets can either be online or they could also take the form of a downloadable application that can be stored on a smartphone or a laptop. However, the key point is that these wallets are connected to the internet. This internet connectivity makes these wallets susceptible to online attacks.
There are several advantages to using hot wallets. A lot of them are easy to set up and free to operate. Also, these digital wallets are compatible with a wide variety of cryptocurrencies and their networks.
There are certain problems associated with these wallets. They can often lead to transaction delays since they are run on third-party servers. Also, they need to be constantly updated which makes them inconvenient to use.
Cold wallets, on the other hand, are wallets that are not connected to the internet in any way. These are paper wallets as well as hardware wallets which were discussed earlier. Since these wallets operate offline, they cannot be hacked and hence provide better security to the cryptocurrency investor. Also, they can be encrypted with biometric information which would help ensure that only authorized users are able to undertake transactions. However, cold wallets can be expensive to set up and maintain. Also, there is always a chance of losing the paper or the device which makes this method slightly prone to risk.
How Investors Choose Cryptocurrency Wallets?
The different types of cryptocurrency wallets mentioned above are suitable for different purposes. The selection of a wallet type depends upon the individual needs of an investor. Some of the factors commonly considered by cryptocurrency investors have been listed below:
- Investment Time Horizon: If the holding period for cryptocurrency transactions is less, then online wallets are more advisable. This is because they are cheaper and more convenient to use when frequent transactions take place. However, if a person wants to hold on to cryptocurrency for a long time, then they are better off choosing offline wallets. These wallets are more expensive to use. However, the additional cost is offset by the increased security which is provided by the system
- User Friendliness: If the investor is not comfortable with complexity and user-friendliness is a key criterion, then they must use online wallets. Online wallets help simplify cryptocurrency transactions. With the help of these cryptocurrency wallets, crypto transactions can be compared to online credit card transactions in terms of simplicity. On the other hand, cold wallets are for seasoned cryptocurrency investors who do not mind using a more complicated interface.
- Variety of Coins: Online wallets already support a wide variety of cryptocurrencies. Also, with the passage of time, as new cryptocurrencies become more popular, they are added to the wallet. However, this is not the case with offline wallets. The types of coins they process are limited. Hence, if investors use a lot of different coins, they must stick to online wallets whereas if they only use a few types of coins, they must use offline wallets.
- Accessibility: Online wallets are accessible from any location. This is because they are available on the internet. Hence, as soon as an investor can connect to the internet, they can access their coins. It is for this reason that online hot wallets are recommended for investors who travel a lot and hence make trading decisions from different geographical locations. On the other hand, if an investor does not travel as frequently, they can use cold wallets.
- Expenses: Lastly, transaction expenses can work out to be significant in the case of cold wallets. Investors must closely understand the transaction charges. They must be aware of how these changes impact the value of their investment. If an investor transacts frequently using cryptocurrency, these charges can quickly add up and start eating into the returns.
The fact of the matter is that cryptocurrency wallets are no longer as new or mysterious as they used to seem a few years back. Investors have been using these wallets to transact in significant volume in the past few years. As a result, it is easy to obtain user reviews and understand the pros and cons of the wallet just by doing some primary research. The key point to be understood is that the selection of cryptocurrency wallets has long-term implications. Changing a cryptocurrency wallet is a complex task and hence investors must be clear about the factors which are important to them and then base their decisions on those factors.
Authorship/Referencing - About the Author(s)
The article is Written By Prachi Juneja and Reviewed By Management Study Guide Content Team. MSG Content Team comprises experienced Faculty Member, Professionals and Subject Matter Experts. We are a ISO 2001:2015 Certified Education Provider. To Know more, click on About Us. The use of this material is free for learning and education purpose. Please reference authorship of content used, including link(s) to ManagementStudyGuide.com and the content page url.
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