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What is a Crypto Wallet & How Does It Work?

April 25, 2022
7
min

A crypto wallet is an essential tool for anyone who wants to buy, sell or trade cryptocurrencies. Crypto wallets work by holding pairs of private and public keys.

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A cryptocurrency wallet is what allows people to store and trade crypto. It can be set up and managed by a centralized crypto exchange (CEX) like Coinbase, Crypto.com, and Gemini. Or, it can be set up and managed by a crypto investor on their own.

Each option has pros and cons. Understanding the kinds of crypto wallets and how they work allows crypto investors to choose the type best suited for them.

What is a cryptocurrency wallet?

Unlike a traditional wallet, a crypto wallet doesn’t actually store currency inside of it. That’s because as digital assets, cryptocurrencies only exist as entries on public databases called blockchains. Instead, a crypto wallet stores cryptographic keys that are used to transfer cryptocurrencies. 

Think of a crypto wallet as more like a wallet filled with credit cards rather than cash. The cards themselves aren’t valuable as pieces of plastic. But someone can use them to spend money that’s linked to the account. One big difference is that, unlike with unauthorized credit card transactions, if a thief spends or transfers cryptocurrencies, it might not be possible to get them back. 

How do crypto wallets work?

Crypto wallets work by holding pairs of private and public keys, which people use to send, receive, and trade cryptocurrencies.  

A public key is a bit like a bank account number. It’s used to create a wallet’s public address, which can be shared with others to receive cryptocurrencies.

A private key, on the other hand, is more like a bank account’s username and password wrapped into one. Anyone who has the private key of a wallet can use the associated crypto—so it should never be shared. Keeping cryptos safe essentially comes down to keeping the private keys inside a crypto wallet secure. 

A private key in a wallet is used to create public keys, and the public keys get hashed (run through an algorithm) to create public addresses. Someone can share their wallet’s public address to receive cryptos and then use their connected private and public key pair when they want to send them. 

Types of crypto wallets

There are many kinds of crypto wallets, in part because wallets are usually specific to one blockchain. For example, Bitcoin and Ethereum have their own blockchains, and Ethereum can’t be sent to a Bitcoin wallet—if someone tries, the Ethereum could disappear. 

That’s one reason many people have multiple crypto wallets: they may need to transfer cryptos that are on separate blockchains. However, some organizations create wallet services that one can use with multiple cryptos. These may require a single login or initial password, and the software then creates and manages multiple blockchain-specific crypto wallets behind the scenes. 

There are two main ways people create and manage their crypto wallets:

  • Hardware wallet. Hardware wallets are generally external hard drives or USB drives that have the wallets on them. They can be kept offline. Companies like Trezor and Ledger design and sell hardware wallets that have more security features than a standard storage device. Paper wallets, or pieces of paper with a QR code or private key printed on them, fall into this category as well. These have largely gone out of fashion as other types of wallets offer safer and easier-to-use options. 
  • Software wallet. Software or digital wallets are virtual wallets that are always connected to the internet. They may be desktop wallets, browser extensions, or mobile wallets. Software wallets are generally free to create, but users may pay transaction fees to the creators if they trade cryptos within the wallet. 

Crypto wallets are additionally categorized based on their internet connectivity and who controls their private keys.

Is the wallet connected to the internet?

Crypto wallets are often defined by their connectivity because there is an important trade-off between usability and security. A wallet that’s connected to the internet could be easier to use for investors who regularly trade cryptos, but it also makes the wallet a potential target for hackers. Wallets fall into one of two categories:

  • Hot wallet. Hot wallets are crypto wallets that are always connected to the internet, Software wallets are hot wallets. 
  • Cold wallet. Cold wallets are crypto wallets that can be disconnected from the internet and kept offline. Hardware wallets are cold wallets.

Who controls the private keys?

Crypto wallets are also separated into categories depending on who controls or has access to the crypto wallet’s private keys. 

  • Custodial wallets. Custodial wallets are crypto wallets that are created and managed by centralized exchanges (CEXes) on behalf of their users. Crypto investors need only create an account on one of these CEXes. The CEX then creates the wallets, and often controls the private keys themselves rather than sharing the private keys with the user. 
  • Non-custodial wallets. Non-custodial, or self-custody, wallets are crypto wallets that people create and manage for themselves. They control and can view their wallet’s private keys at any time. 

Creating a custodial wallet at an exchange and letting a company manage the details can be easier for crypto investors, especially because CEXes often have intuitive interfaces and low fees. Users may also benefit from being able to request a new account password or ask customer service for help if they’re having trouble with their account. 

But crypto investors would need a non-custodial wallet to access cryptos that aren’t available from CEXes on so-called decentralized exchanges (DEXes), or to use other decentralized finance (DeFi) platforms, like a crypto lending project. 

Are crypto wallets safe? 

There are always risks to consider when it comes to crypto wallets. Software wallets have the potential to be hacked and hardware wallets could be lost or misplaced. With all non-custodial wallets, investors risk losing access to their crypto if they don’t know their recovery phrase. These are some of the risks associated with various types of wallets:

  • Custodial wallet risks. Setting up an account with a CEX can be risky because the company might get hacked or wind up being a big scam—it’s happened multiple times. Some CEXes, like Coinbase and Gemini, keep part of their assets in cold storage and have insurance in case they’re hacked. 
  • Non-custodial software wallet risks. Investors don’t need to trust a third party when using a non-custodial software wallet, but they’re now responsible for keeping the wallet secure. They need to be careful to avoid accidentally downloading malware that targets crypto wallets onto their device or connecting their crypto wallet to a service that will steal its funds. 
  • Non-custodial hardware wallet risks. Hardware wallets could be stolen, lost or damaged. There are sad stories of people who threw out or lost hardware wallets with cryptos that would now be worth millions. 

Individual and institutional crypto investors may use a combination of different types of crypto wallets to help keep their investments safe. For example, many exchanges and avid investors keep the majority of their crypto in cold wallets and also have hot wallets for day-to-day trading and investing. 

Factors to consider when choosing a crypto wallet 

When comparing crypto wallet providers, consider:

  • Does the company that makes the wallet have a good reputation?
  • Is retaining control of the private key important?
  • Is the wallet and associated software easy to use?
  • What built-in security features does the wallet have?
  • Will the wallet support the desired cryptocurrencies and non-fungible tokens?
  • Is there a cost to procure and set up the wallet?
  • Is there a fee to use the wallet?

While picking a crypto wallet can be an important choice, it’s not a permanent one. Many people create and use multiple wallets, and it can be easy to switch between wallet providers. 

Five popular crypto wallet options

Investors who are brand new to crypto may need to set up a crypto wallet for the first time. Here are five popular providers and crypto wallets to consider: 

  • Custodial wallets. Custodial wallets are managed by centralized exchanges (CEXes) and used to buy and trade cryptos on those exchanges. Some of the most popular exchanges are Coinbase, Crypto.com, FTX, Kraken, and Gemini.
  • Coinbase Wallet. Several CEXes also create separate software wallets that users can manage on their own. The Coinbase Wallet is a popular example of these non-custodial wallet offerings. 
  • Metamask. Metamask is a browser extension software wallet for Ethereum-compatible networks that can be used with many DeFi projects. 
  • Exodus. Exodus is a mobile app and desktop software wallet that supports multiple cryptos. 
  • Ledger hardware wallets. Ledger sells many models of popular USB crypto wallets. There are a variety of apps and support services that work with Ledger wallets. 

The bottom line

A crypto wallet is an essential tool for anyone who wants to buy, sell, or trade cryptocurrencies. They keep and store a private key, which is essential to sending crypto, and a public key, which is used to accept crypto. Investors can entrust a centralized exchange to keep their wallet or take control of the wallet themselves to gain access to additional parts of the crypto ecosystem.

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