What is a Crypto Wallet? 

A crypto wallet is an application that functions as a wallet for your cryptocurrency, but not in the same way a physical wallet holds cash. Contrary to popular belief, crypto wallets do not actually store cryptocurrency at all. Instead, they hold users’ public and private keys needed to sign for cryptocurrency transactions and provide the interface that lets users access their crypto. 

Wallets enable users to easily view and manage their balance by accessing the public ledger (the blockchain) to display the balance associated with the wallet. They also support cryptocurrency transfers through the blockchain. Some wallets also allow users to perform additional actions with their crypto assets, like interacting with decentralized applications (dapps).

How do Crypto Wallets Work? 

As previously explained, a crypto wallet doesn’t actually store a user’s crypto assets; it simply keeps the keys (public and private) to access them. In public key cryptography, every public key is paired with one corresponding private key. The public key acts as the address, or account number, of the wallet while the private key, which consists of a unique set of codes, acts as the PIN code. Used together, they enable data encryption that is used to verify transactions. 

Just to clarify a bit further – cryptocurrency transactions do not involve sending crypto tokens from one device to another. When tokens are sent, the user’s private key signs the transaction and relays it to the blockchain network. The transaction is recorded on the network and balances in both the sender’s and recipient’s addresses are updated accordingly. 

Do I Need a Wallet for Crypto?

Yes. Securely accessing your cryptocurrency is impossible without an interface that interacts with a blockchain and your private keys. While all wallets can store keys, only hot wallets (more on that below) can interact directly with the blockchain. Therefore, it’s crucial to keep your keys off your hot wallet until you need to use them.

Understanding the Different Types of Crypto Wallets

Crypto wallets fall into two main categories and then can be broken further down into subcategories. The main two categories are software-based hot wallets and hardware (physical) cold wallets. 

Software wallets come in the form of applications for desktops and mobile devices. These wallets are always connected to the internet and allow you to access your cryptocurrency, perform transactions, display your balance, and more. 

Hardware wallets are among the most popular types of wallet because they allow you to store your private keys separately from your device. To make a cryptocurrency transaction, you simply plug the hardware wallet into your computer or device, similarly to a USB drive. Most hardware wallets can automatically sign transactions without requiring you to enter the key, thereby preventing hackers from logging your keystrokes or recording your screen.

Within the hardware category, are paper wallets which are simply writing or typing the private keys or even a scannable QR code on paper. However if you use a paper wallet, take precautions to store it in a safe or safety deposit box to ensure its security. 

From there, wallets can be further differentiated into some other subcategories. Let’s get into the different types and the benefits and drawbacks of each. 

Hot Wallets vs. Cold Wallets – What’s the Difference? 

Hot Wallets

The main distinction between hot and cold wallets lies in their internet connectivity. Wallets that are connected to the internet are ‘hot’, whereas ‘cold’ wallets remain offline. Hot wallets make accessing funds more accessible, however, the trade off is that they’re also more susceptible to hacking attempts. 

Hot wallets include:

• Software wallets
• Web-based wallets
• Desktop wallets
• Mobile wallets
  
  

In hot wallets, private keys are stored and encrypted within the app, which remains online. There are inherent risks to using a hot wallet because computer networks have hidden vulnerabilities that hackers or malware programs can exploit. Therefore storing large amounts of cryptocurrency in a hot wallet is not a recommended security practice. That said, using a hot wallet with strong encryption or devices that store private keys can help mitigate some of the risks. 

Cold Wallets

As we’ve mentioned, a cold wallet is entirely offline, and therefore, is far more secure. The tradeoff, however, for that added security is lack of accessibility and convenience. While using a cold wallet enables users to circumvent hackers, it also makes accessing and transacting your crypto more difficult. 

Cold wallets include:

• Paper wallets
• Hardware wallets like Trezor or Ledger 
  
  

Is a Hot Wallet or a Cold Wallet Better? 

Both wallet options have pros and cons, but choosing which is better will ultimately depend on the user’s preference and needs. For users planning to access their funds frequently, a secure hot wallet that provides easy accessibility may be an option worth looking into. 

Conversely, anyone considering storing a large amount of crypto assets may want to research more secure cold wallet options. 

That said, many users prefer managing their crypto assets using a split approach. In this case, it’s common for cryptocurrency holders to use multiple different wallets to suit specific purposes. 

Custodial vs. Non-Custodial Crypto Wallets

Custodial Wallets

Wallets that are managed by a third party that stores your keys for you are known as custodial wallets. This could be a company specializing in enterprise-level data security systems, or even a cryptocurrency exchange. Custodial wallets are generally more convenient and easy to use for users new to blockchain, or people making daily trades. 

The key difference between custodial wallets and non-custodial wallets is that users do not have full control over their tokens. With a custodial wallet, the private keys needed to sign transactions are held exclusively by the third-party/exchange. To access their keys, users must set up security measures such as two-factor authentication (2FA), facial or fingerprint verification, email confirmation, etc. These security measures typically must be set up before a user can begin making transactions. 

Non-Custodial Wallets

On the flipside, non-custodial wallets require you to take responsibility for securing your keys. When setting up a noncustodial wallet, users are given 12 (or 24) randomly generated words, known as a ‘recovery’ or ‘seed’ phrase. This phrase can generate the user’s public and private keys and serves as a backup in case the user loses access to their device. 

It is the user’s responsibility to write down and securely store their recovery phrase. In the event that the physical copy phrase is lost or inaccessible, the user will lose access to their funds. Therefore, it’s crucial to keep the phrase in a secure location and avoid storing a digital copy of it anywhere.

Is a Custodial or a Non-custodial Wallet Better? 

Custodial and noncustodial wallets each have their own advantages and disadvantages – choosing which option is best depends on your preferences.

If you are prone to losing passwords and devices, a custodial wallet may be the more ideal option. An exchange or custodian is likely to have more reliable security practices and backup options. 

On the other hand, those who prefer to have full control over their funds and are confident in their ability to securely store their keys may feel more comfortable using a noncustodial wallet.

The Final Word 

Ultimately, the type of wallet you choose comes down to your personal preferences, experience level and risk appetite. Each type of wallet has different benefits, purposes, and drawbacks. Given the high risk of storing large amounts of cryptocurrency in a single wallet, a combination of both cold and hot wallets may be an optimal solution, providing both security and convenience.

But as always, it’s up to you to do your due diligence, weigh the options and select the approach that works best for you. 




Interested in more blockchain basics? Check out our other articles on key topics like tokenomics, staking and smart contracts!

Do Your Own Research

All examples provided in this article are intended for informational purposes only. The content of this article should not be considered legal, tax, investment, financial, cybersecurity, or other professional advice. As each individual’s situation is unique, it is essential to consult a qualified professional before making any financial decisions.