Understanding Cryptocurrency Wallets for Absolute Beginners

by Heybit
Understanding Cryptocurrency Wallets for Absolute Beginners

What is a Cryptocurrency Wallet?

The term "wallet" typically brings to mind a physical item used to carry currency, credit cards, identification, and other items. So when we hear "cryptocurrency wallet," we might think of a physical wallet for storing cryptocurrency. However, strictly speaking, a cryptocurrency wallet does not store cryptocurrency. So, what does a cryptocurrency wallet store?

The cryptocurrencies you own exist on a blockchain network shared by all participants. Although the actual cryptocurrencies are not stored in the wallet, the wallet serves as a tool to manage the keys required to authenticate the ownership of the cryptocurrencies recorded on the blockchain network. This is called a private key.

If you lose the private key managed by the wallet, you will not lose the cryptocurrency itself, but you will lose the ability to prove ownership of your cryptocurrency. Therefore, one of the most important tasks in cryptocurrency asset management is to thoroughly manage your private keys.

Classification of Wallets Based on Ownership

Cryptocurrency wallets can be classified based on 1) ownership and 2) internet connectivity.

Ownership refers to the private keys of the cryptocurrency wallet. Cryptocurrency wallets can be categorized based on whether you manage these private keys yourself or someone else manages them for you. Wallets in which you manage the private keys yourself are called non-custodial wallets. Wallets in which someone else manages the private keys for you are called custodial wallets.

When investing in cryptocurrencies, we typically use exchanges. On these exchanges, you can store and invest in cryptocurrencies like Bitcoin and Ethereum. Think of these as accounts, similar to brokerage accounts. The account format provided by the exchanges is referred to as a custodial wallet.

Custodial wallets are extremely convenient because the exchange or a specific institution manages the private keys and the wallet for you. However, there is a risk that the exchange could steal the wallet with malicious intent, or you could lose ownership of your assets if the service is suspended. The FTX incident in November 2022 serves as an example of this.

On the other hand, non-custodial wallets are considered safer than custodial wallets because users manage their private keys directly. This follows the motto, "I manage my assets myself." However, like custodial wallets, if you lose or have your private key stolen, you can lose all your assets. Non-custodial wallets include commonly known wallets like MetaMask.

Classification of Wallets Based on Internet Connectivity

Cryptocurrency wallets can be broadly divided into cold wallets and hot wallets. The classification is based on whether they are connected to the internet. Hot wallets are connected to the network and can only make transactions online. They are called "hot" because they exchange transaction information in real-time. On the other hand, cold wallets are not connected to the internet and are offline, making them also known as offline wallets.

  • Cold Wallet: Stores cryptocurrency on a hardware device disconnected from the internet, offering relatively superior security. Examples include Trezor, Ledger Nano, etc.
  • Hot Wallet: A software wallet connected to the internet, allowing for fast and easy cryptocurrency transactions. Examples include MetaMask, Kaikas, etc.

Hot wallets and cold wallets each have their pros and cons. Hot wallets are convenient for real-time use through the internet, but they are vulnerable to security issues like hacking since the private keys are connected and entered online.

Cold wallets store cryptocurrencies on a hardware device disconnected from the internet and process private keys offline, making them more secure in terms of security. However, they do not allow real-time transactions, which can be inconvenient.