All You Need to Know about Digital Wallets

If you want to invest in crypto, you need to understand wallets. The first thing you need to know is that crypto wallets do not actually store cryptocurrencies. Instead, they store the public and private keys required to buy cryptocurrencies and the digital signatures that authorize each transaction.

So when you pay or transfer crypto, you are not sending the actual tokens from your mobile phone to someone else's. When you think you are sending tokens, you are actually using your private key to sign the transaction and broadcast it to the blockchain network. The network will then include your transaction to reflect the updated balance in your address and that of the recipient. This means that the term wallet is a bit of a misnomer because they do not actually store the money as would a normal wallet. Instead, they read the ledger to show you the balances in your addresses and also hold the private keys that enable you to make transactions.

You may now be wondering what is the difference between a public and private key. A public key is like your bank account number. You don't mind if the world knows this number because it means they can deposit money into your account. The private key is like your pin number or password to that account. In public key cryptography, every public key is paired with one corresponding private key and together they are used to encrypt and decrypt data.

Your crypto is only as safe as the method you use to store it. While you can technically store crypto directly on the exchange you used to acquire the crypto, it is not advisable to do so unless in small amounts. For larger amounts, it's recommended you withdraw the majority to a crypto wallet, whether that be a hot or cold one.

What is the difference between hot and cold wallets?

The difference is simple. Hot wallets are connected to the internet while cold ones are kept offline. Cryptos stored in hot wallets are more accessible and therefore more vulnerable to hackers. In hot wallets, private keys are stored and encrypted on the app itself, which is kept online. Keeping large amounts of crypto in a hot wallet is fundamentally a suboptimal security practice, but the risks can be mitigated by using a hot wallet with stronger encryption. Cold wallets on the other hand are entirely offline. They are not as convenient but what you lose in convenience you make up in security. An example of a physical medium used for cold storage is a piece of paper or an engraved piece of metal.

There are two different kinds of cold wallets - paper wallets and hardware wallets. A paper wallet is a physical location where the private and public keys are written down or printed. The risk here is that the paper is lost or destroyed which may result in unrecoverable funds. A hardware wallet is an external device (usually a USB or Bluetooth) that stores your keys. You can only sign a transaction by pushing a physical button on the device.

You are responsible for securing your assets held in a cold wallet. In order to help you decide what wallet is best for you, it all depends on what you plan to do with your crypto. If you plan to trade day to day, then accessibility will be of key importance which means the hot wallet may be the best option. If you plan on buying a large block of crypto and holding it indefinitely, then it would be wise to go the cold wallet route.

You also need to understand the difference between custodial and non-custodial wallets.

Most web-based crypto wallets tend to be custodial and are offered by exchanges. These are popular with newcomers and experienced day traders. With these wallets, you are no longer in full control of your tokens, and private keys needed to sign transactions are held only by the exchange. You, therefore, need to trust your service provider to implement strong security measures to prevent unauthorized access. A common way is through two-factor authentication (2FA). This could involve the generation of a temporary and unique code that only works for a short period of time. In order to perform any actions that will affect your assets, you will need to enter this code in addition to your password. Other layers of security would include email confirmation, account lock for incorrect passwords, and biometric authentication.

Many exchanges also use a hybrid of hot and cold storage where a portion of the funds are transferred to the company's cold wallet where they can be safe from hackers.

Non-custodial wallets allow you to retain full control of your funds since the private key is stored locally with the user. When starting a non-custodial wallet, you will be asked to write down and safely store a list of 12 randomly generated words, known as "recovery", "seed" or "mnemonic" phrases. From this phrase, all of your public and private keys can be generated. This acts as a backup or recovery mechanism in case you lose access to your device.

In the event the seed phrase is lost, you will lose access to your crypto assets. You need to keep that phrase in a secure location. How would you know which is a better option for you? If you are prone to losing passwords and devices, then it makes more sense to use a custodial wallet, since the exchange or custodian is likely to have better security practices and backup options. That is why it is a popular option for beginners who have little or no experience in trading crypto. However, if you prefer to retain full control over your own funds, you may want to consider a con custodial wallet.

For additional security, you may want to consider multi-signature or multisig wallets that require two or note private key signatures to authorize transactions.

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