All About Cryptocurrency Wallets: A Brief Primer
This article series will explain what a Cryptocurrency wallet is, and how it compares to better-known tools such as bank accounts, credit cards, and cash. The article series will also discuss how different kinds of wallets work and assist by helping users sort and compare crypto-wallets, with the end goal being that users are able to judge the legitimacy of different options, such as whether an option is a scam, or a wallet worth trusting.
What Is A Cryptocurrency Wallet?
As you may well already be aware, Cryptocurrency is represented by hashes (computer codes) – long strings of numbers, letters, and symbols, that indicate who a given amount of ‘money’ belongs to at a given time.
Featured Cryptocurrency Wallets
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- What Is A Cryptocurrency Wallet?
- Featured Cryptocurrency Wallets
- Private Property Ownership
- Third-Party Arbitration
- Managing Ownership of Cryptocurrency
- What Are Some Ways That Different Kinds Of Cryptocurrency Wallets Work?
- Securing your Wallet
Private Property Ownership
One of the central problems throughout the history of personal accounting and the ownership of any kind of private property is that ownership of property or capital needs to be verified before it can be honestly transacted with. In other words, it must be ascertained that the person purporting to trade property, shares, or cash is the true owner of this capital before trading it away. Clearly, if such a person is not the true owner of the capital, the trade itself is fraudulent and invalid.
Humans have dealt with this historical problem in many different ways. One of the more enduring forms of solution has been one or another version of the ‘trusted third-party’ system. This implies that while the buyer and seller may not be able to trust each other, given that they may well be strangers and have met for the first time, possibly because they both have an incentive to trade dishonestly in that both parties could potentially benefit from a dishonest trade (such as the seller providing low-quality goods and the buyer providing invalid money), that both the buyer and the seller can mutually trust a third party, whose incentive to act dishonestly is significantly lower than either buyer or seller. Instead, the incentive of the third party is to ensure an honest trade, for this party’s reputation will be enhanced through the facilitation of honest trades in all situations.
A common variant of the said third party is, of course, the bank. One of a commercial bank’s primary purposes is to be charged with holding a customer’s money for them and then dispensing such money on command by the customer. The bank also follows procedures of identity verification and issues cards only in the names of verified customers. In this way, banks can be reasonably sure that a vast majority of their customers’ capital is legitimately held. Banks also communicate with other banks in order to facilitate trades between customers of different banks. In this way, even customers of different banks can use the third-party system to verify identities of buyer and seller on their behalf, which significantly reduces the chances of either party to a given trade from committing fraud. In this way, a transaction can occur within a minute – in the time that it takes a customer of a shop to pull out a credit or debit card, have that card’s data captured on an electronic device, and have banks mutually confirm that the transaction is valid.
For this service of identity validation and capital holding, banks charge fees on accounts and on transactions that are known in advance to customers of the banks. Banks may also charge currency conversion fees, if currencies from different countries are being traded, and may charge other fees such as ATM fees for customers to withdraw cash from their accounts. Sometimes, banks may take a number of days to process a transaction, especially one between different banks or between banks from different countries.
In certain cases, a bank may gain a reputation for being insecure, should it become known that funds have been stolen from users. In many cases, companies registered as banks are not legally allowed to hold or trade in Cryptocurrencies, and so cannot provide this service to their customers. This means that, in most cases, customers who wish to hold or trade Cryptocurrencies cannot use the services of commercial banks that they are used to trading government-issued currency with. Also, Cryptocurrency holders may prefer not to transact with banks anyway, even if they were allowed to, as a result of the flaws of the banking system, such as account fees, transaction fees, being limited to centralised currency that is controlled by a government, transaction delays, and security that doesn’t match a user’s requirements.
Managing Ownership of Cryptocurrency
To solve this problem for Cryptocurrencies, the concept of a Cryptocurrency wallet had to be invented. The Cryptocurrency wallet made banking one’s own Cryptocurrency a personal responsibility, allowing each person theoretically to ‘be their own banker’.
As you may imagine, this concept of being one’s own banker is both highly liberating and confers a large responsibility. If you lose the keys to your house or car, and someone else attempts to take possession of them, you will probably still be able to use the legal system to gain them back. If someone steals money from your credit card, in most cases your bank will refund you, as they are insured against theft. However, should you lose access to your Cryptocurrency, in most cases, it is permanently lost, because there is no central ‘controller’ through which to petition for its return.
This apparently frightening news should not dissuade you from investing in or using Cryptocurrency – it should only serve to inform you that as a Cryptocurrency holder, there are reputable vendors and best practices that you should make use of in order to safeguard your holdings.
As such, there are many options for safeguarding your Cryptocurrency, all of which are known as ‘Cryptocurrency wallets’. These ‘wallets’ have the purpose of verifying any trades that you authorise, and of making it easier to buy, sell and trade Cryptocurrency. You can learn more about types of wallets from Coin Outlet‘s 7 Types of Bitcoin Wallets.
What Are Some Ways That Different Kinds Of Cryptocurrency Wallets Work?
There are different methods for holding Cryptocurrencies, some of which are more secure than others. Each method has its own pros and cons, and this section will explore methods that are used today.
Hot or Cold Wallet?
The simplest delineation between wallets is whether or not the wallet in question is connected to the Internet. If it is, the wallet can be considered a ‘hot’ wallet, and if it is not, the wallet can be considered a ‘cold’ wallet. In this way, it is advised to use hot wallets for frequent, smaller transactions for buying and selling online, and to use cold wallets for long-term, safer storage, because it is significantly more difficult and expensive to compromise a user’s cold wallets than their hot ones. This is similar to how a person shouldn’t keep more than a small amount of cash on their person (to protect against pickpocketing) and should impose a daily limit on their current bank accounts (to protect against being forced to withdraw funds), but that they protect their investment accounts with multiple factors of security.
The solution most similar to traditional banking is to use web-based wallets, usually ones that are bundled along with Cryptocurrency exchange websites – places where you buy and sell Cryptocurrency units. Coinbase, Circle and Bitgo are examples of platforms that store Cryptocurrency keys on web servers. These do not require downloading any applications, and therefore require a minimum in personal responsibility from the user, and tend to be easy to use. Many such online wallets are fairly well secured, according to cryptographic principles, similarly to traditional banks, but as a disadvantage, because they store large amounts of money, they tend to be targeted by thieves. High-profile thefts of Cryptocurrency, such as those from Mt Gox in February 2014 ($850 million worth), Bitfinex in August 2016 ($77 million worth), and NiceHash in December 2017 ($64 million worth), indicate that online wallets that store the keys to large amounts of Cryptocurrency are top priorities for thieves and hackers. At the time of writing, odds are in favour that at least one professional group of hackers is busy working out a way to attack the next major Cryptocurrency key storage that they can.
Software wallets can be run as applications on a desktop computer, laptop computer, or mobile phone. These can be used while the device is not connected to the Internet, but will only ‘update’ to the Cryptocurrency network when they are connected again. Desktop applications include Armory, mSIGNA, Multibit, and Hive. Mobile applications include Mycelium and Blockchain. One very useful addition to mobile applications is their use of scanned QR codes, which allow a user to pay immediately, similarly to how they might with a credit or debit card. Since the storage of the private key is no longer done online, any potential hackers will have to attack an individual computer that the key is stored on. This substantially reduces the payoff of a given hacking operation, as the hackers, if successful, will only be able to steal from the individual computer that has been compromised.
The next level up of security involves using a hardware wallet. The private keys belonging to an individual user are stored on a hardware device, similar looking to a flash drive, and usually protected by a PIN, and the private key cannot be extracted in plain text. These can protect against computer malware such as viruses, key loggers, and malicious web browser extensions. There are no known high-profile thefts of Cryptocurrency from hardware wallets belonging to individuals. If you are planning on any long-term storage of Cryptocurrencies, a hardware wallet is one of the more secure options available to you.
Trusted companies that manufacture hardware wallets include Trezor, Ledger HW.1, Pi Wallet, and KeepKey. When a hardware wallet is initially set up, it produces a code known as a ‘seed’. Store this ‘seed’ code in a safe place, and if your hardware wallet is stolen, you will be able to recover all of your funds using the seed code, and provided that the thief does not know the PIN code that you have assigned to the hardware wallet, they will not be able to access any of your money for themselves. So, while hardware wallets are not completely foolproof, they are certainly one of the most secure options for Cryptocurrency storage.
The final type of ‘wallet’ worth discussing here is the paper wallet, which is different from all the other forms of wallet. Unlike any of the other kinds of wallet, paper wallets need to be converted into a software form before they can be bought or sold (except in rare cases where your paper wallet contains the correct amount of currency that you want to trade and the trading partner trusts that the wallet contains exactly this amount). Paper wallets can be created by printing out or writing out a private key by hand, or printing out a QR code. This is the most low-tech option for creating a Cryptocurrency wallet, and as long as no copies of the code are used online, paper wallets are immune to cyber-attacks and key loggers (until such time you convert them to software again). However, like printed cash, paper wallets can be subject to physical theft, fire, and becoming wet, damaged or unreadable.
Securing your Wallet
It should become clear from the above paragraphs that no single form of Cryptocurrency storage is completely foolproof, because, theoretically, if its rightful owner can access it, then so should anyone else who possess the same information. However, possessing only your own private keys (in the same way that you never tell anyone your e-mail password or your bank account password) is the best way to secure your digital assets against theft and fraud. Requiring multiple private keys in order to transact is a further security step one can take. We shall explore one way to add security factors to your wallet, in the form of multisignature authentication. You can learn more about multisignature authentication from Bitcoin Wiki‘s article Multisignature.
What is Multisignature Authentication?
For some online bank transactions, your bank may send a message to your mobile phone and request a confirmation that it is truly you who authorised a transaction. This is called two-factor authentication, as it would require someone to compromise both your computer and your mobile phone in order to steal funds. Cryptocurrency wallets can be set up with the same technology, meaning that authorisation has to come from multiple sources in given situations (such as when money is sent from a certain account, or when money transferred is over a certain value), or, for especially security-conscious users, multisignature authentication can be required for all transactions.
Multisignature authentication is usually designated by two figures – one specifying the number of signatures required, and one specifying how many sources that valid signatures can come from. Such systems can include “2 of 2”, “2 of 3”, “3 of 5”, and an infinite number of other options. Each type of multisignature authentication has different situations where it is appropriate. Where the number of signatures matches the number of sources (such as with 2 of 2) all parties or devices must consent to sign. Situations like “2 of 3” allow people to use ‘cold storage’ to a high degree of security, by having one key at home, copies of a second key with different trusted friends, and the third key in a safety deposit box. This would protect your Cryptocurrency from home robbery, or from the loss of trust of the friend, or from the loss of your deposit box, as long as you immediately change your key if any one of these events occurs.
By Which Variables Can We Sort And Compare Cryptocurrency Wallets?
We can compare Cryptocurrency wallets by their security offered, their anonymity, their ease of use, and by any extra services that they offer, as well as by the specific kinds of Cryptocurrency that each wallet supports, such as Bitcoin, Litecoin, Ethereum, and DASH. These are the variables that are of key importance to users, and the wallet(s) that you may end up selecting will be the one(s) that offer(s) you the correct combination of all of these variables for the time and financial cost to you.
Security is an important concern, given that the more value you hold in Cryptocurrency, the more that security is worth to you. Anonymity is of particular importance to anyone who does not want their transactions tracked, such as political activists living under totalitarian regimes. Ease of use is of importance to beginners (but should never be sacrificed for security).
In conclusion, you may well find yourself using multiple options of wallets available, depending on your needs for security, anonymity, ease of use, and other features. You can find one listing of wallets on CryptoCompare‘s article Wallets. In this article series, we will review ten of the most popular wallets available in detail, which should help you choose which wallet(s) is/are right for you.