Understanding How a Cryptocurrency Wallet Works
A cryptocurrency wallet is a secure digital wallet used to store, send, and receive digital currency like Bitcoin. Most coins have an official wallet or a few officially recommended third-party wallets. In order to use any cryptocurrency, you will need to use a cryptocurrency wallet.
Below we discuss how digital wallets work and give some advice on which wallets to use.
TIP: If you want a simple wallet-exchange solution (so you can jump right into trading cryptocurrency) see our page on “How to Trade Cryptocurrency – For Beginners.”
How Does a Cryptocurrency Wallet Work?
Cryptocurrency itself is not actually “stored” in a wallet. Instead, a private key (secure digital code known only to you and your wallet) is stored that shows ownership of a public key (a public digital code connected to a certain amount of currency). So your wallet stores your private and public keys, allows you to send and receive coins, and also acts as a personal ledger of transactions.
Which Cryptocurrency Wallet Should I Use?
We typically suggest using an official (or officially endorsed) wallet for any given coin. So, for Bitcoin we would suggest using the Bitcoin Core Wallet, for Litecoin we would suggest Litecoin Core, and for Ethereum we would suggest either Ethereum Wallet or MyEtherWallet.
There are also custodial wallets where you don’t control your private keys directly like Coinbase (although people are advised against keeping all their funds on an exchange, exchanges generally double as custodial wallets as well).
If you are new to cryptocurrency, then either:
- Download the official (or officially endorsed) wallet from the official website.
- Sign up for a custodial wallet service like Coinbase (which handles a wallet and exchange with one account).
- Purchase a hardware wallet like TREZOR.
- Or, use a universal software wallet like the ones noted above.
If you know what you are doing, there are a wide range of different wallets to choose from which offer different pros and cons.
TIP: There is no one single wallet that stores every coin. So you’ll need to figure out which wallets you need based on which coins you want to invest in or use (or vice versa).
TIP: You can store all ERC-20 tokens (tokens created on the Ethereum platform AKA Ethereum-based tokens) in an ERC-20 friendly wallet like MyEtherWallet. Many Ethereum-based tokens also have their own wallets as well (check the coin’s official Github or website for official wallets).
IMPORTANT: Never share your wallet password or private key and never enter your password or private key anywhere (unless you are accessing your wallet via private key and password). To send coins and receive coins you only need to share your public wallet address (your “public key”). This of course only applies to wallets where you control your keys directly. If you use a custodial wallet, then use two factor authentication and don’t share your password. If you use TREZOR, don’t share your pin, seed, passphrase. Etc.
What Is A Bitcoin Wallet? The basics of cryptocurrency wallets using a Bitcoin wallet as an example.
Are Cryptocurrency Wallets Secure?
Cryptocurrency wallets are all built to be secure, but the exact security differs from wallet to wallet. Generally, like your usernames and passwords, the security of your wallet comes from you using best practices. We suggest not keeping more currency than you need at one time in a single wallet that you use frequently, using google authenticator for extra layers of protection, encrypting your wallet, and using an official (or officially endorsed wallet).
It’s smart to backup your wallet and private keys and to encrypt them. At least one backup should be on a CD or thumb drive to ensure that you have a “hard copy” laying around. If you lose your wallet or your keys, then you lose the currency connected to it!
TIP: As a rule of thumb don’t keep more currency in your digital wallet than you would in your real one! You can learn more about securing digital wallets from bitcoin.org.
TIP: If you use Coinbase, consider using their vault service to add an extra layer of protection to coins you aren’t actively trading or using.
Are Bitcoin Wallets Anonymous?
The answer is about the same as the answer to whether cryptocurrency is anonymous or not. The answer is that cryptocurrency is “pseudonymous.” Due to the open source and public nature of transaction blockchain ledgers, there are little bits of public data that can be used to backward engineer someone’s identity (in theory). For most of us, the answer then would be, “it’s pretty darn close to anonymous.”
Types of Wallets
There are several types of wallets you can use including online, offline, mobile, hardware, desktop, and paper. Each “type” refers to what type of medium the wallet is stored on and whether or not the data is stored online. Some wallets offer more than one method of accessing the wallet – for instance; Bitcoin Wallet is a desktop application and a mobile app.
Here is a quick breakdown of the different types of cryptocurrency wallets:
Desktop Wallet: The most common type of wallet. Typically an app that connects directly to a coin’s client.
Mobile Wallet: A wallet that is run from a smartphone app.
Online Wallet: An online wallet is a web-based wallet. You don’t download an app, but rather data is hosted on a real or virtual server. Some online wallets are hybrid wallets allowing encryption of private data before being sent to the online server. Some wallets let you control your private keys, some are custodial (you don’t control your keys directly).
Hardware Wallet: Dedicated hardware that is specifically built to hold cryptocurrency and keep it secure. This includes USB devices. These devices can go online to make transactions and get data and then can be taken offline for transportation and security.
Paper Wallet: You can print out a QR code for both a public and private key. This allows you to both send and receive digital currency using a paper wallet. With this option, you can completely avoid storing digital data about your currency by using a paper wallet.
TIP: A full wallet that downloads the full blockchain of a coin is called a “full node” wallet. These wallets can take up a lot of space and use a good bit of energy since they need to download the entire blockchain and keep it updated. Bitcoin Core, Litecoin Core, and Ethereum Wallet are examples of full node wallets. If you don’t have a lot of disk space free to commit to running a node, consider one of the other wallet options instead.
TIP: Watch out for browser extension malware if you are using online wallets, you may want to use a different browser for your online wallet than you do for your day-to-day internet browsing.
TIP: The term “hot wallet” describes a wallet connected to the internet. The term “cold wallet” describes a wallet not connected to the internet (for example a hardware wallet unplugged and in a safe.) When cryptocurrency is in “cold storage” that means it is being held offline in a “cold wallet.” Funds you want to use like cash should be in hot wallets, funds you want to store long term are best held in “cold storage” in an offline wallet. Hot wallets are considered “hot targets” (i.e., they are targets for hackers). Thus, if you have a “hot wallet,” make sure you have as many layers of protection on it as you can (two factor, strong password, all security settings on, etc).
IMPORTANT: Remember that with any wallet, if you lose your private key, then you lose your money. That is true for paper wallets, hardware wallets, or any other wallet type. The reason you lose your keys doesn’t matter; there is no way to reclaim your cryptocurrency without them. Further, if your wallet is hacked, be it with a custodian or not, and your funds are taken, then you lose your money. Its not fun, but it is the way it is. So make sure to use best practices and keep your wallets secure.