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Cryptocurrency is an extremely high-risk and complex investment. Don’t invest unless you’re prepared to lose all the money you invest. You are unlikely to be protected if something goes wrong.
Forbes Advisor has provided this content for educational reasons only and not to help you decide whether or not to invest in cryptocurrency. Should you decide to invest in cryptocurrency or in any other investment, you should always obtain appropriate financial advice and only invest what you can afford to lose.
Crypto wallets are among the most misunderstood and misrepresented aspects of cryptocurrency trading, and are often wrongly described as a kind of digital wallet for your cryptocurrencies.
It’s important to understand what a crypto wallet is because your crypto assets’ security depends on it. So, here’s a primer on what a crypto wallet actually is and how it works.
Understanding crypto wallets
It’s first important to reiterate that cryptocurrencies such as Bitcoin and Ethereum are not tangible. No physical coins are minted (you can disregard the images that depict them), no notes are printed, and there is no computer file that acts as a digital equivalent to physical cash.
Crypto assets only exist as records on distributed – or shared – computer ledgers. That is to say, they’re only lines on ledgers that prove someone owns whatever it is they own.
It’s similar to your bank balance. It only represents the money that your bank is obliged to give you on demand, it’s not a physical pile of money locked in a safe somewhere. And, of course, you need to use your debit card details and PIN or account number and sort code to actually access your funds.
So it’s not the actual cryptocurrency you own that you store in a crypto wallet. What’s actually in a crypto wallet is a pair of ‘keys’. These keys are long alphanumeric strings of text that are practically impossible to guess.
Your public and private crypto wallet keys are necessary to use your crypto assets, whether that’s trading them for other currencies or spending them on goods and services.
Your keys are what you use to digitally sign and authorise a transaction using the crypto assets assigned to your crypto address. So, whoever holds your keys can do whatever they want with your crypto holdings. It’s for this reason that keys are securely stored in a crypto wallet.
Your wallet’s public key is something akin to a postal or email address, or bank account number. You need to generate and share your public key each time you want to receive a deposit.
Your private key, on the other hand, is generated by your wallet and should be kept secret. Your private key effectively ‘unlocks’ the transaction sent to your public key.
There’s an axiom in the crypto world that pithily explains the importance of keeping these credentials secure: ‘Not your keys, not your coins’.
Types of crypto wallets
So a crypto wallet secures the pair of keys you need to spend or trade your crypto assets, but there are different kinds of crypto wallets to choose from, and each has its benefits and shortcomings.
The kinds of wallets you’re likely to encounter are: hot wallets, cold wallets, hardware wallets and paper wallets.
Hot wallets
Hot wallets are effectively online wallets, and can be either custodial or non-custodial. Custodial hot wallets are those offered by crypto exchanges – the places from which crypto traders buy their crypto.
Accessing a custodial hot wallet is as simple as signing into your crypto exchange account, making them a very convenient way to store your keys.
The major drawback of a hot wallet, whether custodial or non-custodial, is that they’re a target for hackers. Many crypto exchanges, from Mt Gox in 2011 to KuCoin in 2020, have been compromised and millions of dollars’ worth of crypto have been stolen.
Exchanges have learned lessons from all the hacks over the years and responded by tightening security. Hackers, in turn, have continued to develop exploits.
Cold wallets
Cold wallets are storage methods that don’t involve a connection to the internet. This can be either a hardware wallet, which is like a USB device, or a paper wallet.
Hardware wallets
Hardware wallets are PIN-secured, physical devices that contain your private keys and plug into a computer in order to authorise transactions. In theory, they are safer against hackers because they’re not connected to the internet and they’re secured with a PIN.
Once you close the ‘air gap’ between the hackers and your wallet by plugging it into a web-connected computer, you arguably expose yourself to breaches, especially if your computer’s security is lacking.
Paper wallet
A paper wallet is exactly what it sounds like: public and private keys generated by a key generator program and printed on two pieces of paper, typically along with associated QR codes.
Despite being unhackable, paper wallets are generally discouraged. For one thing, paper is difficult to keep safe and intact. Then there’s the issue of using a key generator service that hasn’t been compromised. Also, when scanning your QR codes, it’s possible for someone with access to your camera to steal your keys.
Whatever kind of wallet you choose, it’s important to remember you are responsible for your wallet’s security too. Never click a link without first hovering over it to reveal where it’ll take you, ignore emails from senders you don’t recognise, and always check any offers that seem too good to be true online before taking any action.
If you’re using a hardware wallet, be sure to keep your computer’s operating system up to date with security patches and consider using security software.
