How crypto wallets work
To really understand how wallets operate, we must first understand how cryptocurrencies function. Cryptocurrencies are simply digits on a digital ledger called a blockchain.
A blockchain is a distributed record of activities (usually transactions) from a distributed network of wallet owners.
It is with an associated pair of keys called private and public keys, that every coin or token will exist on a blockchain. That being said, every coin or token exists on a blockchain through an associated pair of keys, called the private and the public key. Precisely, every exchange or transfer you will ever execute from a wallet will be done with these pairs of keys.
Hence, crypto wallets are literally what the word ‘wallet’ implies— portable storage. However, unlike your physical wallet, crypto wallets do not hold funds, rather they hold the keys that give you access to the funds.
These funds, like we saw earlier, are designated figures on a blockchain and are assigned to respective public-keys. And every public key is derived from a private key.
The private key where the value and essence of every wallet lies. The security and sovereignty of the funds of every wallet is dependent on how secure these keys are.
Also, if you have the key by heart, then your brain becomes your wallet. If you have it on paper, on a flash drive, or in an application, then that becomes your wallet.
More on wallets and keys
The relationship between the private key and the public key is that the public key is generated from the private key using a mathematical function.
For a better perspective, think of your public key as your Twitter username and your private key as your password. While your password is indirectly needed to send a tweet, we only need your username to recognize you, call your attention, or make a tweet about you, without necessarily knowing your password.
Similarly, every wallet holder is seen and identified via their public key, which acts as their username on the blockchain. However, to send the funds from a wallet, the private key is needed to digitally sign-off ownership of the funds to another public key or user.
That being said, the limits to what you can do from a wallet is dependent on what type of wallet you are using, which brings us to the types of the wallet we have. Wallets are generally classified into two which are Software and hardware.
Creating transactions with a wallet
Cryptocurrency wallet transfers are like writing a check. Most software wallets come with a digital transaction template, which allows users to fill in a receiving wallet address, enter a corresponding amount, and in a sense, seal it with a digital signature, using the wallet’s private key. After which it is broadcasted across the network, for validation.
This is why having access to the private key of any wallet is having full control of the funds in the wallet.
Choosing a wallet
Earlier, we said wallets (which could be software or hardware) are firstly storage for keys. However, depending on your need, and budget, there are various wallet options out there for you to choose from.
Over the next half of this piece, we will be looking at various wallet types, with regards to their state, functionalities, their pros, and cons.
Existing somewhere between hardware and software wallets, this is as basic as it gets with wallets.
Comparing this with other wallet types is like comparing the good old paper and pen to Microsoft Word or a tablet. They all are writing materials, however, ink on paper is limited in many ways. On the contrary, using word processing applications or a tablet gives you a whole lot of leverage and user experience.
That being said, every other function — like creating transactions, propagating it across the network, exploring transaction data on a network, and so on — can not be executed from a piece of paper.
Personally, all of my long-term holdings are stored up in a paper wallet. It’s simple to generate, costs nothing, reduces the impulse to change your mind, and it gives you full control over your funds, assuming your keys are not backed in any device with internet access.
As one looking to use a paper wallet, it is important to note that, you are responsible for the safety of your paper wallet, losing it without any backup is losing your funds completely.
This is a notch farther from paper wallets. It’s simply storing your private key in hardware stores, like a flash drive. Over the years, hardware wallets have evolved from being hard-drive-like stores to having extra functionalities like generating new keys, signing transactions when connected to a supporting application and so on..
Even more, some wallets come with the luxury of a screen that allows users to create transactions before passing them on through a computer or a mobile device unto the network.
Even more important than choosing any of these brands is getting it directly from the company. Sadly, there have been reported cases of tampered hardware wallets, with their keys being stolen, after which they are repackaged, and sold-off.
Like the word “software” implies, a software wallet is basically a software application that executes all of the basic functions of a cryptocurrency wallet, like sending funds, generating an address, creating new keys, and so on.
Similarly, like it is with every software, software wallets come in various states, device type functions, and capacities. Here are the software wallets out there.
This wallet operates locally from a desktop computer or laptop. The whole ledger of a blockchain is usually synched into these wallets upon installation and its first usage. It does not need any other wallet somewhere for it to function, as it contains the whole blockchain data. Once a transaction is created here, it is sent over to the network once the desktop device comes online.
This wallet is great for executing any full node wallet function. By the way, full node wallets are wallets that have the whole blockchain saved up in their local storage, without requiring any server or node to share data with in order to operate effectively.
This is as light as they get, with regards to storage. Online wallets completely rely on other full node wallets to carry out functions that require having a record of the blockchain. However, they can execute basic wallet functions like creating a transaction, validation of a transaction, and so on.
This leaves them at the mercy of other nodes. This is mostly used for mobile wallets. In some cases, they rely on a third-party wallet provider to store their keys.
With regards to storage capacity, these wallets rely on full node wallets on the network to fetch some information from the network. In some cases, some mobile wallets have the user’s private keys stored up in the wallet providers’ database.
This is simply handing over control of your funds to a third party. Mobile wallets are considered the most vulnerable because mobile devices are more prone to malware attacks.
The rule of thumb is that, if anyone controls your key they should be liable in the event that it gets missing. If you, however, do not trust them to provide these freedoms, then you should not give them that responsibility.
A safer option is, only store funds you can afford to lose in mobile wallets. Anything above that should be stored in a paper wallet or a hardware wallet.