Cryptocurrency is all the rage, and each day, new people decide to give this fintech innovation a try. For some, it’s straight-up curiosity, and for other users, it’s aspirations of realizing the kind of gains that early investors in Bitcoin and other early-stage crypto assets enjoyed.
Finally, some are being driven towards the cryptocurrency market because a non-inflationary asset, although wildly volatile, still represents a better option than many national currencies. In nations such as Venezuela and Zimbabwe, the reckless economic policies of the governments have led to extreme currency devaluation, and this has made crypto assets attractive to some citizens.
It doesn’t matter why you are getting into cryptocurrency. However, before you sign up to Coinbase, LocalBitcoins, or CEX.io, for example, you should consider how you are going to store your digital assets. Whilst this is particularly important to those planning to store large quantities of crypto over a long period of time, even if you just want to play with the technology with $10 or whatever, you still really should understand how to use a cryptocurrency wallet and how it functions.
How Does a Cryptocurrency Wallet Function?
As Bitcoin evangelist Andreas Antonopoulos has argued previously, a lot associated with Bitcoin (and by extension, the rest of the crypto industry) is terribly misleading. For example, there are no coins. In fact, nothing physical is ever stored or transacted in any digital currency.
Just as confusing is the fact that the method of storing crypto assets is called a wallet. In fact, this only serves to make people think that some piece of the software is storing the digital asset for you. It’s not. If you are using the software, all it is doing is managing cryptographic keys.
A cryptocurrency wallet is nothing more than two of these keys – a public address (for receiving) and a private address (for sending). If you have these two keys written down, you possess all the credentials needed to transact with the cryptocurrency network you want.
Wallet software will generate the key pair on your behalf and will also prompt you to password protect the keys. Finally, it will provide some methods of restoring your wallet in case if your mobile phone or computer would be stolen or lost, for example.
Advanced users may not require any software to create their wallet (offline random number generators can technically be used). The point is, your keys give you supreme control over the Bitcoin (or fractions of Bitcoin) that are associated with them. You can send them to any address on the network if you have your private key. That also means that anyone else can send them to any other address on the network if you control your own private key. This is VERY important.
What Kinds of Digital Currency Wallets are Available?
The main purpose of a digital asset wallet is to protect that private key. If you manage to lose it together with the wallet restoration information you were prompted to record when creating it (common on most modern wallet software), you will lose the money associated with the private key as well. In such a case, you will never get it back.
Most cryptocurrency wallets (all software and hardware solutions) allow users to send their cryptocurrency holdings from the wallet directly. In order to achieve such convenience, however, compromises must be made in terms of the software’s overall security. You will notice that the simpler a digital asset wallet is to use for daily spending, the less secure it generally is.
This isn’t really a cause for concern. It just means that, like with fiat money, different storage solutions are preferable to different applications.
Where are your entire life savings? Probably being looked after in a bank, right? You wouldn’t want to wander the streets with all your net worth in your pocket to take a trip to the shops.
Digital asset storage is the same. The most secure, least convenient solutions are reserved for large holdings, whereas your online, hot wallet might contain a few hundred dollars. An annoyance if it was ever compromised, but hardly going to cause most folks any real financial issues.
That said, there are some wallets that are surprisingly popular that do not offer either security or convenience. Below, we’ll consider these but only as an example of bad cryptocurrency storage.
A custodial wallet is a cryptocurrency wallet operated by a company on the users’ behalf. It might be a service provider like Coinbase or it could be a designated custodial wallet service provider, like those recently-launched by Fidelity Investments. Different companies offer different levels of protection. Therefore, the company providing custodial services to you, you may or may not be protected in the event of a security compromise at the firm itself.
Since they are trusted to keep millions or billions of dollars’ worth of value safe, they provide the perfect honey pot for online criminals. Examples of cryptocurrency exchanges being hacked over the years are pretty common.
Generally speaking, unless you are paying (a lot) to store your cryptocurrency with a private company, you should avoid custodial wallets. Use them whilst you use the service offered (exchange, shopping, etc.) but don’t consider them as storage for your wealth. If you don’t possess your private key, it really isn’t your crypto!
A non-custodial-type wallet is much more appropriate for keeping your digital assets safe. The main difference between the two is that the users themselves are responsible for protecting their private keys. This places a lot more responsibility on the user but it also means that they can transact with the cryptocurrency of their choice without requiring anyone’s grant permission first. Since this is one of the main value propositions of Bitcoin and other crypto assets, it makes no sense to sacrifice this in favor of a custodial wallet prone to compromise.
There are two main types of non-custodial wallets. They are known as a hot wallet (online) and cold storage (private key always kept offline).
Hot Cryptocurrency Wallet
Hot wallets are pieces of software that are built to keep your private keys safe but also good for day-to-day spends. They are called “hot” because they are usually open on computers or mobile phones that are connected to the internet. As such, they are still vulnerable to compromise. Since they represent a much less lucrative target than an exchange wallet, personal hackings are much less likely, particularly if you follow a strong internet safety protocol.
Both mobile and desktop wallets are considered “hot” and therefore make an ideal method keep some crypto for online shopping and other such activities but you really don’t want to keep a lot of value in your hot, online wallet.
Cold Cryptocurrency Wallet
Cold storage providing the ultimate in digital asset security. Any crypto storage that ensures the private key is NEVER online is far superior to a hot wallet. In a cold storage solution, the pair of cryptographic keys are generated entirely offline.
If you go about creating the necessary randomicity yourself and arrive at your own key set, this is known as a paper wallet. It represents the absolute height of security when correctly setup but this is not an easy task. Even Andreas Antonopoulos is not confident in his own abilities to correctly create a paper wallet and if you are reading this, I am going to guess that you are a less able computer user than him.
Although paper cryptocurrency wallet is potentially the hardest-to-compromise cryptocurrency storage method, it is not very convenient for anything but the longest-term storage. The problem with them is that once used to transact funds, they must be considered void and the user must create a new paper wallet. Understandably, this is an annoyance if you are wanting to use your holdings frequently.
For users wanting a high level of security but who are not confident in creating their own paper wallets, a hardware wallet is a perfect solution. These are specially-designed units that create and store private keys offline. You can then use the device in conjunction with software to allow for transactions to be sent from the keypair without ever exposing the private key to a live internet connection.
They sound miraculous but even hardware wallets have been known to suffer vulnerabilities. This usually means that the attacker is able to possess the hardware but not always. However, hardware wallet compromises are rare and certainly a lot less common than crypto exchange hackings. In terms of a balance of security and convenience, they represent the optimum digital asset storage option for most users.
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