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Fundament of the week: How do crypto wallets work?

If you want to use or trade any cryptocurrency, you will need to use a cryptocurrency wallet. It is a secure digital form of a classic wallet that is used to store, send and receive cryptocurrencies such as Bitcoin or Ethereum. Most cryptocurrencies have their own official wallets or recommend some of the wallets developed by third parties. In this article, you will learn how cryptocurrency wallets (crypto wallets) work.

Introduction to crypto wallets

A Bitcoin wallet , the same as any other crypto wallet, always consists of two parts. The first part is the public key (also called the public address), which can be shared with other users. The second part is the private key , which must never be revealed to the public . Likewise, the wallet consists of a pair of cryptographic keys. A public Bitcoin address can be compared to an email address, while your private key can be compared to your password.

The private key is used to encrypt transactions, while the public key is used to decrypt them. That is why the private key must be kept secure. Anyone with access to a private key is also the owner of the wallet, it is the same as if they had access to your bank account password . The public key is used for sharing with third parties and as proof that you are the owner of the Bitcoin address. In other words – the public key is like your bank account number – IBAN.

The combination of private and public keys creates a digital signature . It is a special type of digital cryptography that aims to create a secure digital link to the identity of the crypto wallet owner. Digital signatures prove your ownership and allow you to control your property.

The crypto-wallet can therefore be a piece of paper with information written on it. It will simply contain a public and private key, written in plain text with the appropriate QR codes. That is all you need for the safe storage of cryptocurrencies. They cannot be saved in one place, such as a digital file on a USB drive. All information about them is stored in a decentralized block managed by thousands of people around the world. The very nature of digital files predetermines them for effortless and indefinite copying.

Filmmakers and musicians have been facing this problem since the arrival of the Internet and peer-to-peer technology. Should cryptocurrencies worked on a similar principle, the whole system would have collapsed like a house of cards. Anyone could create new coins on the go without any restrictions. This is exactly what blockchain technology prevents from happening. Whenever you try to send bitcoin, blockchain miners are checking if the required quantity can be sent. In other words, miners check the entire history of your transactions because your bitcoins are not stored in a single physical location.

Types of crypto wallets

Crypto wallets are divided into 2 basic categories:

Hot wallets – constantly connected to the internet

Pros – These wallets are usually provided by various online services that also allow cryptocurrency trading. As a result, you can easily and quickly perform a practically unlimited number of transactions. Online wallets are usually very cheap or even free (because they are often open-source). Mobile wallets can be very convenient because most people today own smartphones. They are easy to use when making transactions, as you only need to use the phone’s camera to scan the QR codes of the address of receiving the crypto wallet.

Cons – A wallet that is permanently connected to the Internet. However, it has one very obvious weakness – it is vulnerable to hacker attacks. Hot wallets as such are not suitable for the long-term storage of cryptocurrencies. Unless you fully trust the providers of the service that offers the crypto wallet.

Cold wallets – offline

Pros – These wallets are not connected to the Internet, which makes them very secure for long-term storage. The wallet only connects to the Internet when you send cryptocurrencies. You do not need an internet connection to receive them, because as the receiving party you do not have to confirm the transaction. The transaction is performed in the blockchain network, where the entire transaction history of your wallet is stored. The sender only needs to know your public address. Thanks to this, cryptocurrencies are also ideal as a form of a gift. Another advantage is that you can get a crypto-wallet for free if you decide to use the paper version we mentioned previously.

Cons – Just as you must defrost frozen food before consumption, you must first connect the cold wallet to your computer before using it. This makes the whole process a bit longer. In addition, beginners may have problems with the setup process. Another potential disadvantage is that hardware wallets can be expensive, but the price is derived from an additional level of security.

Another 4 basic subcategories

Hardware wallets

  • – public and private keys are stored on separate hardware devices and are written in digital form, access is locked and secured with a password.

Paper wallets

  • – public and private keys are written on paper (they can also be written on more durable material for longer storage)

Online wallets

  • (including mobile wallets) – Private keys are often owned by a wallet provider

Software wallets

  • – public and private keys are stored in a computer program and entered in digital form, while access is locked at least with a password

Cryptocurrency Exchanges

Cryptocurrencies on the stock exchange are also stored on wallets, but you only know their public addresses. Their private keys are stored by the cryptocurrency exchange. In reality, you do not have full control over your cryptocurrencies on the cryptocurrency exchange. If the servers are shut down or the cryptocurrency exchange services are blocked, you will not get to your cryptocurrencies. Therefore, in the long run, we recommend storing cryptocurrencies in wallets from which you own a private key.

What is “master code” or “seed”?

It is very important to keep your master code (or seed) of your crypto wallet safe. We could also call the master code (seed) your main password . This is the key to your cryptographic secrets and it is not just an ordinary password or PIN code. Rather, it is a combination of randomly selected words created by your device during the initial setup. If you lose access to your device, you can unlock access to your crypto-savings on another device of a similar type, but only with this combination of words.

The most commonly used standard is BIP 39 . As a result, your device uses a set of 2048 words to generate 2256 different combinations of 24-word master code. If this number doesn’t seem that complex to you, or you find it difficult to imagine exponential numbers, then we will write it for you in its full form:

115, 792,089,237,316,195,423,570,985,008,687,907,853,269,984,665,640,564,039,457,584,007, – 913,49,45,684,97,129,639,984,97,129,639,984,97,129,639,936.

This is approximately 1,158×1077.

By comparison, the estimated number of all atoms on earth is 1050, so the chances of anyone guessing your master code and gaining access to your finances are astronomically low.

In any case, we recommend that you do your own research before choosing the right crypto wallet. Do not blindly follow any recommendations, not even our own. The research itself is a mantra that is often repeated in the crypto world, and this is especially true when we talk about the security of digital assets.

Jakub is a crypto trader and founder of Trader 2.0 project, which helps hundreds of traders from central Europe to understand cryptocurrency trading and its challenges. Jakub not o...

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