How Do Cryptocurrency Wallets Work?

A crypto wallet is a software that “stores” your crypto assets, like cryptocurrencies and crypto tokens.

Technically, crypto wallets don’t actually store anything but a pair of digital keys. It is these keys that allow you to access your wealth in crypto, that is recorded on a global distributed ledger, namely the blockchain.

Now, if this sounds too confusing for you, don’t worry. We’ll offer you a much simpler way to think about cryptocurrency wallets.

What exactly is a crypto wallet?

Let’s first consider what a debit card does. Without getting into the details, a debit card contains a metallic chip that an ATM reads in order to know the bank account that the debit card is associated with.

The ATM will then ask the holder to insert a PIN. If the PIN is valid, then the ATM user has access to his or her funds virtually without going to a bank and without communicating with a teller.

Debit cards don’t actually store your money. If you damage your debit card and then replace it with a new one, you will find that your account balance remains unchanged even at the time when the debit card becomes damaged.

This is because the information pertaining to how much money you have in your account is stored electronically in your bank’s private ledger.

Your debit card is only a tool to help the ATM communicate with the bank. If you insert the right PIN for the appropriate account number, and you decide to withdraw cash, the ATM will tell the bank to deduct money from your account.

So, what is the connection between a debit card and a crypto wallet?

Well, your crypto wallet acts like a debit card. The crypto wallet is associated with a pair of digital keys — the public key and private key. The public key is like an account identifier. The private key is associated with the password or PIN that you set up to unlock your crypto wallet.

When you want to send cryptocurrencies to someone, you first unlock your wallet with a password. If everything goes well, your crypto wallet can begin communication with the blockchain (it’s a ledger, but decentralised). When you make a transaction, your wallet tells the blockchain, “Hey, Wallet X wants to send N amounts of crypto to Wallet Y. Please update the ledger accordingly.”

The blockchain will dictate the amount of crypto you have left over, and will dictate the amount of crypto the recipient has now.

In summary, your crypto wallets don’t actually store cryptocurrencies, but instead the credentials to update the blockchain to send and receive money. So, you will need at least one crypto wallet in order to send and receive cryptocurrencies.

Likewise, your private key is NOT the same as your wallet password or PIN. You can change your password or PIN, but you cannot change your private key. This is why you must ALWAYS keep your private key… well.. private.

If anyone has access to your private key, that person can hack into your crypto wallet and send your hard-earned money their way.

Important: Your public key is NOT the same as your wallet address. The wallet address (which still looks like gibberish) will be given to you when you create a new wallet, and you use this address to receive cryptocurrencies.

Hot wallets vs cold wallets — what’s the difference?

In general, crypto wallets can be categorised into two types: hot wallet and cold wallet.

• A hot wallet is a type of crypto wallet that requires an active and constant connection to the Internet to access its functions, hence the term hot. These are arguably the most popular types of crypto wallets out there due to their accessibility and ease of use.
• A cold wallet is a type of crypto wallet that stores your private keys and addresses in an offline environment disconnected from the internet, hence the term cold storage. A cold wallet still requires a client software that runs on a computer to manage your assets and portfolio. However, when not in use, a cold wallet can be taken offline (not connected to a computer). You can still receive cryptocurrencies even if your cold wallet is not connected to the Internet.

Wait, how is that possible?

Remember the debit card analogy? Your cold wallet (or hardware wallet as some may call it) is just a device that contains the account credentials, which enables the client software (the proverbial ATM) to talk to the blockchain — the public ledger that records your ownership of cryptocurrencies.

Custodial vs. Non-Custodial Wallets

In addition to the method of storing the assets themselves, crypto wallets are also classified based on how the user accesses and holds the keys, of which there are two types: custodial and non-custodial wallets.

Custodial Wallets

Imagine a custodial wallet like a bank account. With this type of wallet, a company takes care of your money (cryptocurrency) for you.

They help you keep track of it, and it’s easy to use. But, just like a bank, they control your money and its safety. If something happens to that company or their security is breached, your money could be at risk.

Examples of custodial hot wallets include all centralised exchange wallets provided by big exchanges such as Coinbase or Binance.

Non-custodial Wallets

Now, think of a non-custodial wallet like your own personal safe at home. You’re in charge here. You have complete control over your money (cryptocurrency).

These wallets give you more security because you manage everything yourself. But, it’s like keeping your cash in a safe—if you lose the key or forget the code, there’s no one to help you get it back.

Examples of non-custodial wallets include the Easy Crypto Wallet, our very own, locally designed non-custodial hot wallet that is built to simplify the crypto experience for all users.

We’ve designed the Easy Crypto Wallet to combine the best of both worlds, featuring seamless recovery features via Social Recovery and encrypted cloud backups, while also empowering users with full control and ownership of their assets as a self-custody wallet.

The EC Wallet also features the latest in security tech with MPC (Multi-Party Computation) signing for authenticating transactions, and also the ability to create multiple accounts and individual addresses for better on-chain privacy.

Get Started: Learn more about the Easy Crypto Wallet.

That being said, other non-custodial options include Trust Wallet, MetaMask, and Exodus Wallet where you have control over your private keys.

In summary:

• Custodial wallets are easier to use, but you surrender your control and “custody” of your assets to trust another company to take care of your money.
• Non-custodial wallets give you more control and security, but you’re responsible for keeping everything safe. It’s a trade-off between convenience and control! (unless you’re using the Easy Crypto Wallet that is, you get the best of both worlds!)

Further reading: Learn more about custodial vs. non-custodial wallets.

Which is safer, hot or cold wallets?

It is arguably safer to store large amounts of cryptocurrency in a cold wallet.  Because cold wallets aren’t always connected to your device and the Internet, there is a significantly reduced chance of getting your funds stolen from hackers.

One way hackers can steal your private keys is by using malware such as keyloggers (which is commonly and unknowingly downloaded via an email/software phishing attack). Keyloggers can reveal what you type in your device; hackers can use this data to access your hot wallet.

However, cold wallets are a different story. Even if a hacker manages to discover your user credentials, without the physical presence of the hardware, they can’t gain access to your funds.

The only downside is that as cold wallets are not connected to the internet you can’t easily send or spend your crypto. If you are wanting to make frequent transactions it is a trade-off between speed and security.

A great example of cold wallets are Trezor or Ledger (shown below)

That being said, hot wallets are constantly getting better at crypto storage and protection. As a user, you also have the option to add layers to your crypto security through 2FA (Two-Factor Authentication), and MPC Signing (with Easy Crypto Wallet).

Other types of crypto wallets

Web Wallets

A web wallet is a wallet that is stored inside a website such as an exchange like Binance or Kiwicoin. Storing assets on exchanges or web wallets are necessary for people trading through exchanges, but an unnecessary risk to others who just want to “HODL” — i.e. investing in long-term.

Issues with web wallets are that you do not hold the private keys to your wallet – the exchange does.

In 2014, Mt Gox, a Japan-based exchange that at the time handled 70% of all bitcoin transactions, was hacked. (When we say hacked, Bitcoin itself wasn’t hacked, passwords to access the private keys of the exchange were stolen, allowing the hackers access to their wallets).

This resulted in their users and personal business accounts losing about 740,000 bitcoins (6% of all bitcoin in existence). That equated to 780 million dollars at the time of the heist.

There a several ways that the security of your assets can be compromised when stored on an exchange:

• Your computer is hacked or your lose your password.
• Your exchange’s remote server is hacked.
• Your exchange goes bankrupt.
• The FBI or other authorities seize the exchange servers.
• There is a software bug in your wallet.
• An unauthorised person accesses your smartphone or computer while you are logged in.

Paper Wallets

A paper wallet is another type of ‘cold’ wallet because it is stored offline and keeps your private key safe so you can access your crypto when required. These types of wallets were widely used in the early years of cryptocurrency due to its accessibility. However, their usage have since declined in favor of modern wallets with better security features and cross-platform support.

To spend the Bitcoin on your paper wallet, you need to open up a hot wallet and ‘sweep’ the address to move the coins from the paper wallet into the new wallet.

Storing a private key on a paper is quite secure but extremely inconvenient in use. Moreover, you will have to enter your private key in one of the wallet types described above to make a transaction.