Crypto wallets are an essential part of the financial services system run in the blockchain network. But not all wallets are the same.
Contrary to popular belief, crypto wallets do not physically hold cryptocurrencies like the wallet in your pocket. Instead, they store the public and private keys required to buy cryptocurrencies. Just as the assets it hold, crypto wallets are digital but also resemble trading accounts offered by traditional brokerages.
Here are the basics of cryptocurrency wallets and how to choose the right storage option for you. We will also discuss the most popular alternative to crypto wallets – cryptocurrency trading accounts.
What is a crypto wallet?
A crypto wallet is a software app that allows you to safely store your cryptocurrency. Because it can be used in the same way as a wallet that you use to store cash or cards, it is called a "wallet". These items are not stored in the wallet. Instead, the wallet stores the passkeys that you use to sign for cryptocurrency transactions. It also provides an interface that allows you to access your crypto.
Modern cryptocurrency wallets make it possible to access the blockchain from anywhere. Sending cryptocurrency was a manual task when it was first introduced. You had to enter a long string of characters, known as keys, to perform the transaction. Of course, there was always the risk of mistyping them. But the majority of the work is automated today by software.
Satoshi Nakamoto, Bitcoin's creator, was the first to have a crypto wallet. Hal Finney owned the second wallet. He corresponded with Nakamoto and was reportedly the first to use the Bitcoin client software wallet. As a test, Nakamoto sent him 10 Bitcoins. This was when the cryptocurrency craze started.
Why do you need a crypto wallet?
A crypto wallet is an alternative to cryptocurrency exchange accounts that hold your crypto for you. Therefore, if you want to ensure that nobody has access to your funds, then you should use a crypto wallet. Also, by using a wallet you can connect to decentralized applications such as decentralized exchanges (DEXs) and others.
The term "wallet" is a bit misleading as crypto wallets do not store cryptocurrency the same way cash wallets. They read the public ledger and show you the balances of your addresses. Additionally, they hold private keys that allow you to make transactions.
Remember that cryptocurrency transactions are not a way to send crypto tokens from your phone to another's phone. To send tokens, you use your private key to sign and broadcast the transaction to the blockchain network. Your transaction will be included by the network to reflect the updated balance of your address and that of the recipient.
What is the private and public key? A key is a string of random characters that can be used to generate a number. A public key can be shared with anyone, but your private key should not be shared. Public-key cryptography pairs every public key with one corresponding public key. They are used together to encrypt or decrypt data.
Types of wallets
Wallets can be classified in a few different ways. There are two types of crypto wallets – non-custodial and custodial.
A custodial wallet is hosted by a third party and it stores the private keys to your wallet. This could be a company providing enterprise-level data security solutions businesses use to protect and secure their data. Many cryptocurrency exchanges provide custodial wallets to their customers. Non-custodial wallets allow you to take full responsibility for your keys. When talking about crypto wallets, most of the time we are referring to this kind of wallet.
Crypto wallets are also classified as hot and cold. A hot wallet is connected to the internet or to any device that has an internet connection. A cold wallet does not have a connection. Each one of these crypto wallets can exist using software, and hardware or it can be simply written on a piece of paper.
Given the many different wallet types, you may find a wide range of combinations, such as non-custodial software hot wallet, a non-custodial hardware cold or hot wallet, or a custodial hardware cold wallet.
Cold wallet
A cold wallet is completely offline. Although they may not be as convenient as hot wallets they are much more secure. A piece of paper or an engraved piece of metal are examples of physical media that can be used for cold storage.
Cold wallets are:
Paper wallets. It refers to an actual piece of paper where you write down your private and public keys, for safekeeping them in a physical place, such as a safe. This is often safer than keeping your funds in a hot wallet because remote hackers cannot access the keys that are kept safe from phishing attacks. However, there is the risk that the paper may be lost or destroyed, which could lead to irrecoverable funds. Hardware wallets. This is an external device, usually a USB or Bluetooth device, that stores your keys. A physical button can be used to sign transactions, and other ill-intended individuals cannot access it. It is best to keep any cryptocurrency assets offline in a cold wallet if you don't need immediate access.
When using a cold wallet, the security of your assets is your responsibility. It is up to you to ensure that your assets are not lost or stolen. To increase security, you should separate your private and public keys and keep them offline. Keep your physical wallet safe in a deposit box.
Hot wallet
The major difference between cold and hot wallets is how they connect to the internet. Hot wallets are always connected to the internet, while cold wallets are always offline. This makes hot wallets more accessible, but they are also easier to hack by malicious actors.
Examples of hot wallets:
- Web-based wallets
- Mobile wallets
- Desktop wallets
Hot wallets store private keys and keep them encrypted online. Hot wallets can pose a risk because hackers and malware programs can target computer networks. It is not a good security practice to keep large amounts of cryptocurrency in one hot wallet. However, you can mitigate the risk by using hot wallets with stronger encryption or devices that store private keys within a secure enclave.
Investors may want to connect or disconnect their cryptocurrency holdings from the Internet for different reasons. It's common for cryptocurrency holders to have multiple cryptocurrency accounts, including hot and cold ones.
How to open a crypto wallet
Before setting up a crypto wallet you need to decide what type of wallet you want and what would be most beneficial for your purposes. As mentioned before, you can set up a crypto wallet of several types – hardware or software wallets.
The instructions will typically include three steps: download the associated software to your PC, write down the recovery passphrase to your private keys, then connect the hardware device or open the wallet with a password for software wallets.
Here are the exact steps you will need to follow to set up a new crypto wallet:
Choose a crypto wallet
If you intend to hold crypto long-term a hardware wallet (cold wallet) is the most secure, although it is the most difficult option to set up. When using a hardware wallet, your private keys will be kept in an offline device, separate from your computer, phone, and other devices. This adds security.
However, if you want to ensure you have easy access to your crypto, you may choose a mobile or desktop crypto wallet. You can find many crypto wallet applications on the app store.
Download the software
Regardless of the chosen type of crypto wallet, you will have to download and install the corresponding software on your device.
After you have purchased a hardware storage unit, such as a Ledger or Trezor, you will need to follow the instructions for setting it up. But even for the hardware wallet, you will have to download the associated software to your desktop.
To create a mobile wallet, you have to install one mobile wallet app on your device. Some of the most popular mobile crypto wallets are MetaMask, Exodus, and ZenGo, but there are many other great wallets.
Save the private keys
During the setup process, you need is to back up your private keys. It’s recommended that you write it down on a piece of physical paper. This backup is usually in the form a passphrase of 12 to 24 words, also known as your recovery phrase or seed phrase. This recovery phrase is needed in case you lose your device or you want to open your crypto wallet on another device. If you lose the recovery phase, you will lose your funds. If you are using a hardware wallet, it needs to connect to your device to enable any actions.
Regardless of the chosen type of wallet, they all have a user interface, which makes it easy to send and receive cryptocurrency.
Desktop wallets often include extensive portfolio tracking graphs or charts. This allows you to track the value of your assets in many different ways according to your preferences.
After you create and save the backup recovery phrase, you can accept cryptocurrency payments.
Crypto wallet vs. crypto exchange
Think of your crypto exchange account as a brokerage that can store your crypto for you, and Wallet is like a traditional cash wallet that gives you direct and complete control over your own crypto assets.
Crypto wallets are also offered by crypto exchanges. However, these are accounts you create on a centralized platform, and are called custodial crypto wallets. This means that your crypto is stored by the crypto exchange and you don’t have access to the private keys of the wallet. Also, it’s up to the exchange if the crypto is held in hot or cold storage.
Crypto exchange wallets, or accounts, should be used with caution. Cybercriminals are attracted to cryptocurrency exchanges due to their many security vulnerabilities. You may not get your cryptocurrency back if the exchange goes out of business. The security of the assets is left entirely to the exchange.
For example, Coinbase, one of the largest crypto exchanges, has submitted a 2022 report to the Securities and Exchange Commission in which it is stated that “custodial held crypto assets may be considered to be the property of a bankruptcy estate, in the event of a bankruptcy, the crypto assets we hold in custody on behalf of our customers could be subject to bankruptcy proceedings and such customers could be treated as our general unsecured creditors.”
General unsecured creditors have a lower priority on the bankruptcy creditors list. If there are not enough assets that can be liquidated and meet the financial requirements of higher-priority creditors, you could lose your crypto assets in the event your custodial wallet firm declares bankruptcy.
In contrast, crypto wallets grant you absolute access to your funds, but the security issues are entirely up to the owner. Having a non-custodial cold storage wallet is the safest way to keep your crypto secure and unreachable from criminals looking to gain access to your cryptocurrency. These non-custodial wallets are also needed to access decentralized exchanges (DEXs) but require users to be more knowledgeable about blockchain transactions.
To access a crypto exchange account, you need to have access to your email, but a crypto wallet requires you to safely store your private keys or hardware wallet.
Crypto wallet vs. crypto trading account
Unlike a crypto wallet which can be used to trade crypto if you set it on a centralized crypto exchange (CEX), a crypto trading account allows rate fluctuations trades.
A cryptocurrency trading account is a provisional concept, as by that we mean a brokerage account that provides access to the international market for cryptocurrency trading. This means that cryptocurrency is not a priority area of operation of such accounts, but rather one of the several groups of instruments along with fiats, such as stocks, indexes, forex, commodities, bonds, and ETFs.
Trading accounts have lower trading fees but also fewer crypto assets. You need first to sign up for a trading account with a regulated brokerage like CAPEX.com, deposit funds and log in directly from your browser or through a dedicated mobile or desktop app.
When trading cryptocurrencies, the CFDs (contracts for difference) are stored in your account and are more liquid than the underlying crypto assets. However, you should be aware that CFD trading is fast-moving and requires close monitoring.
The funds you hold in your CFD trading account are used as a margin. This means that you can gain greater exposure while keeping the initial investment low. A CFD trading account will allow you to speculate on any price movements. This means you can profit when the prices go up, but you may also make a profit when prices drop. You can also close positions and withdraw the money at any moment. However, your position might lose money if the market moves against you, and remember that leverage can increase both profits and losses.
Unlike crypto exchanges, traditional brokerages are under strict regulations from financial authorities and are required to be members of a compensation fund.
With CAPEX.com, you can trade CFDs on over 2,000 markets including the most popular cryptocurrencies and invest in more than 5,000 stocks and ETFs with ownership, including ProShares Bitcoin Strategy ETF.
Final words on crypto wallets
There is no such thing as a “one-size-fits-all” solution when it comes to crypto wallets. Every type of wallet offers different advantages, but there are also trade-offs. It's up to you to decide which wallet is best for you and what your needs are.
A hot wallet is the best option for those who have a high-risk tolerance and want to make quick, regular online payments. If you are a bit more cautious and want to keep your coins safe, an offline secure device may be the best option.
If you are interested in trading popular crypto assets rather than owning them, then you may want to choose a CFD trading account.
A trading account offers faster settlement times, lower transaction/network costs, and higher security. Trades are not affected by cryptocurrency network congestion, fee volatility, or delays in confirmation. You might also want to use your trading account if you are looking for a higher variety of trading assets, including crypto and blockchain-related stocks and funds.