What is a cryptocurrency wallet? A beginner's guide

Understanding cryptocurrency wallets

A cryptocurrency wallet serves as a digital application designed to store your cryptocurrency, akin to a physical wallet for cash and cards. Rather than holding tangible items, it safeguards the cryptographic keys necessary for authorizing crypto transactions, providing user access via an interface.

Modern cryptocurrency wallets democratize blockchain accessibility. In the early days, sending cryptocurrency involved manual processes, such as inputting lengthy keys. Present-day software streamlines these tasks.

The inaugural cryptocurrency wallet belonged to Satoshi Nakamoto, Bitcoin's creator. Following Nakamoto, Hal Finney, an early Bitcoin contributor, possessed the second wallet. Nakamoto sent Finney 10 bitcoins for testing purposes, igniting the cryptocurrency phenomenon.

Cryptocurrency wallets represent software applications installed on computers or mobile devices like smartphones or tablets. They leverage internet connectivity to connect to the blockchain network of the specific cryptocurrency in use. Unlike traditional wallets, cryptocurrencies aren't physically stored anywhere but exist as fragments of data within a decentralized database. These data fragments are dispersed across the database, with the wallet aggregating those linked to your public address and presenting the total amount within the application interface.

Transacting with cryptocurrency via these applications is straightforward. Users can send or receive cryptocurrency through various methods facilitated by the wallet. Typically, the process involves inputting the recipient's wallet address, specifying the desired amount for transmission, digitally signing the transaction using the private key, allocating an amount for the transaction fee, and executing the transfer. Receiving cryptocurrency is even simpler—a sender inputs your address, follows a similar procedure, you acknowledge the payment, and the transaction concludes.

Security measures for cryptocurrency wallets

Ensuring the safety of your wallet is crucial, given that cryptocurrencies are prime targets for hackers. Protective measures include securing the wallet with a robust password, implementing two-factor authentication for exchanges, and storing significant amounts offline.

Cryptocurrency trading platforms

Cryptocurrency exchanges now offer custodial key storage, but it's wise to exercise caution when using this service. These platforms are prime targets for cybercriminals.

Moreover, if an exchange goes bankrupt, there's no guarantee of retrieving your cryptocurrency. For instance, Coinbase disclosed in its quarterly report to the Securities and Exchange Commission in May 2022 that custodially held crypto assets could become part of a bankruptcy estate. In such cases, customers may be treated as general unsecured creditors, potentially risking loss of assets.

To enhance cryptocurrency key security, consider transferring your keys from your wallet to cold storage and securing them in a vault, safe, or deposit box. Increasing the complexity of accessing your cryptocurrency makes it more challenging for criminals to exploit. This strategy not only safeguards your keys from loss but also prevents potential denial of access by entrusted parties.

Seed phrases

Many contemporary wallets produce a twelve-word mnemonic seed phrase. For instance, "airport bedroom impression sample reception protection road shirt..." appears random but is generated and linked to your keys by your wallet. This phrase serves to restore the wallet in case of loss or damage. It's crucial to securely store these words since anyone who finds them can access your cryptocurrency.

Identifying the optimal cryptocurrency wallet

Exploring the multitude of wallet options available is crucial, considering the diverse features offered. Reading numerous reviews can help you identify a wallet that aligns with your requirements while prioritizing key security measures.

Types of cryptocurrency wallets

There are two primary wallet types: custodial and noncustodial. Custodial wallets are managed by a third party that stores your keys, often utilizing enterprise-level data security systems. Some cryptocurrency exchanges offer custodial wallets. Noncustodial wallets require you to manage key security yourself, typical for most device-based cryptocurrency wallets.

Wallets also fall into hot and cold subcategories. Hot wallets are connected to the internet or a device with internet access, while cold wallets remain offline. Additionally, wallets are categorized as software, hardware, or paper, each of which can be either hot or cold.

Therefore, you might have a noncustodial software hot wallet, a noncustodial hardware wallet (hot or cold), or a custodial hardware cold wallet. These are the most common configurations, but other combinations exist.

Hardware wallets

Hardware wallets are highly favored due to their capability to store private keys externally. Resembling USB drives, these devices boast numerous features in modern iterations.

By simply plugging the hardware wallet into your computer or device, you can execute cryptocurrency transactions. Most hardware wallets automate the signing of cryptocurrency transactions, eliminating the need for manual key entry. This feature thwarts potential hackers from logging keypresses or capturing your screen.

Typically priced between $100 to $200, these devices include notable brands like Ledger and Trezor. Regarded as cold wallets, hardware wallets lack an active connection until plugged in.

Software wallets

Software wallets encompass applications designed for desktop and mobile devices. These wallets are installed on computers and mobile devices, enabling users to access cryptocurrency, conduct transactions, view balances, and offer additional features. Some software wallets integrate functionalities like exchange services, particularly those developed by cryptocurrency exchanges.

Certain mobile wallets facilitate swift payments in brick-and-mortar stores using near-field communication (NFC) or QR code scanning. They typically support iOS or Android platforms. Examples of software wallets include Trezor, Electrum, and Mycelium. Generally, software wallets are categorized as hot wallets.

Paper wallets

In the early days of cryptocurrency, users would record their keys on paper, known as paper wallets. These evolved to incorporate keys and QR codes for scanning by mobile device wallets. However, paper wallets are prone to damage or loss, leading many crypto owners to abandon them.

Nevertheless, using a paper wallet is still viable if stored correctly in a secure location such as a safe or deposit box. Periodic checks are advisable to ensure it remains intact and undamaged.

Identifying the most secure cryptocurrency wallet

The most secure cryptocurrency wallet remains disconnected from the internet and any internet-enabled devices. Additionally, it should not restrict your access to your cryptocurrency due to the custodian's financial problems. Several wallets marketed as "secure" utilize wireless connection technology, which savvy cybercriminals can exploit.

Is a cryptocurrency wallet necessary?

Yes. Accessing your cryptocurrency requires your private keys and a blockchain-accessing interface. While all wallets can store keys, only hot wallets can access the blockchain. Therefore, it's crucial to keep your keys off your hot wallet until necessary.

Investing in cryptocurrencies and Initial Coin Offerings ("ICOs") carries significant risk and speculation. This response is not a recommendation by Investopedia or its authors to invest in cryptocurrencies or ICOs. Due to the uniqueness of each individual's situation, consulting a qualified professional before making financial decisions is advisable. Investopedia does not guarantee the accuracy or timeliness of the information provided herein.