What are cryptocurrency wallets, and why do you need them? Here’s our starter guide…
The concept of a “wallet” is easy enough to get your head around when it comes to holding your fiat money safely: it’s a container into which you can put folding pieces of paper or discs of metal for later retrieval and redemption. Considering you store fiat money in a wallet to spend, it’s only natural that the term is also used when talking about cryptocurrencies like Bitcoin or Ethereum – but that’s where thing’s get a little difficult.
A wallet isn’t a wallet
One of the biggest confusions surrounding cryptocurrency wallets stems from their name: like a fiat wallet stores fiat currencies, it’s fair to assume that a cryptocurrency wallet stores cryptocurrencies – fair, but inaccurate.
In reality, a cryptocurrency wallet holds keys. These keys are used to electronically sign transactions – in the same way a pen-and-ink signature is added to the bottom of a cheque, but with significantly improved security – which are then broadcast by client software to be included on the blockchain.
It’s this blockchain, a distributed and irrevocable ledger, which actually holds the cryptocurrency, not the wallet – and that gives a cryptocurrency wallet features a fiat wallet lacks. It’s possible, for example, to have two or more people holding the same wallet, or to have it so transactions can only be made if two or more people agree to sign them. Many cryptocurrencies support so-called “seeds”, too: an initial secret which is used to generate a near-infinite supply of individual addresses, all of which are combined in a single wallet.
These seeds can be backed up, too, often using a user-friendly format such as Bitcoin’s mnemonic phrase system – allowing you to quickly restore a lost or accidentally deleted wallet without losing a single unit of cryptocurrency.
The most common form of cryptocurrency wallet is known as a “hot wallet”, which simply means it can be used to make transactions directly. If you have an Ethereum wallet on your phone, a Bitcoin wallet on your laptop, or a Ripple wallet on your desktop, you’re using a hot wallet. If you hold your cryptocurrency on an exchange or other trading site, it should also be considered to be in a hot wallet – and one for which you do not control the keys, making this typically the riskiest form of hot wallet.
Hot wallets are the most convenient type of wallet, allowing you to quickly send and receive cryptocurrency at will. They’re also the least secure, and are frequently the target of attack – both physical, such as the theft of a phone known to hold a cryptocurrency hot wallet, and electronic, with malware actively spreading and seeking out hot wallets to drain.
The best practice approach to cryptocurrency use mimics that of most people’s fiat currency use: keep only walking-around-money in your hot wallet, and store the rest more securely. In fiat terms, that typically means a bank; in cryptocurrency terms, that means a cold wallet.
A cold wallet is the opposite of a hot wallet: where a hot wallet allows the user to spend currency directly and at any time, a cold wallet requires that the user jumps through a series of hoops before any cryptocurrency can be transferred.
The most common form of a cold wallet is a paper wallet. As the name implies, a paper wallet is printed on physical paper – or, for those looking for something more robust, etched into metal. The paper wallet requires, at a minimum, two items: a public address, to which cryptocurrency can be sent, and the private key with which transactions can be signed.
Because a cryptocurrency wallet holds no currency itself, a cold wallet can receive without restriction: even printed on paper, locked in a safe, and sunken to the bottom of the sea, a cold wallet will happily receive transactions. To spend cryptocurrency, however, requires use of the private key – which means physical access to the paper wallet.
To throw an additional spanner in the works when it comes to paper wallets, it’s considered best-practice to use its private key only once: when you’re ready to spend, use the key to sign a transaction moving a portion to your hot wallet and the remainder to a new cold wallet using a newly-generated private key. This process, known as “sweeping”, guards against disclosure of the cold wallet’s private key. Once swept and emptied, the original cold wallet should be discarded.
As the name implies, a warm wallet sits between cold and hot wallets. A warm wallet offers the ability to make transactions, unlike a cold wallet, but with greater security and tighter controls than a hot wallet.
The most common form of warm wallet is a hardware wallet, a dedicated device which generates keys, signs transactions, and broadcasts them to the network via a connection to a host computer. When disconnected from a host PC, a hardware wallet is effectively a cold wallet: there’s no way to use it to send cryptocurrency without physical access, though it is free to receive. When connected to a PC and unlocked, a hardware wallet acts much like a hot wallet – but one with enhanced security, as the private key is never exposed to the host system.