Storing your cryptocurrency is one of the most important aspects of investing in this new asset class, and every investor should take the time to understand what digital wallets are, how they work, why they’re important, and how to set one up.
What is a digital wallet?
Simply put, digital wallets (also known as crypto wallets) are software programs or physical devices that allow you to protect, store and manage digital coins and tokens. Wallets are able to locate your assets on the blockchain, transfer ownership between different parties, and push updates to different ledgers.
How do digital wallets work?
Contrary to popular belief, digital wallets don’t literally store your coins or your tokens. — those assets are kept on the blockchain. Wallets do however, store the keys that are used to transact and secure your assets. Each “key” is a long, random string of numbers and letters that helps protect your crypto.
There are two types of keys, public and private.
Public keys are used as a public address for digital wallets. Users can share their public keys with the world, and 3rd parties are able to send tokens to the wallet by using the public key as a destination address. Think of a public key as a bank account number you share with outside entities that wish to send you funds.
Private keys are what enable funds in a given digital wallet to be able to be accessed, used and spent. Without the private keys, any digital asset sitting within a wallet is untouchable. An analogy for your private keys would be your PIN number or the password to your banking app. For this reason, you do not want anyone else to get their hands on your private keys.
Digital wallets make storing private keys a bit more practical through the use of seed phrases, or strings of English words. Words are easier to remember than random strings of numbers and letters, which makes your private keys memorizable. For example, a private key may be something like cute-clip-usual-artwork-imitate-volcano-galaxy-loyal-wool-tag-sausage-earn, as opposed to a string of hundreds of random numbers and letters.
For example, if you downloaded a mobile app to create an XRP wallet, but then wanted to upgrade your phone a few months later, you could simply download any XRP wallet on your new device and enter the private key you were given when creating the initial wallet, automatically generating it on your new phone.
What are the different types of digital wallets?
There are two major types of digital wallets: software and hardware.
Software wallets, also known as hot wallets, are always connected to the internet. They can be installed as programs on your computer, mobile apps on your phone, or extensions in your web browser. There are even wallets that are designed to be accessed directly from a website.
Most software wallets are great when it comes to convenience. Your assets are easily accessible, usually through an app on one of your digital devices. You can trade your assets through CeFi or DeFi platforms or send them to friends or family, all with the click of a button. The downside is that your private keys live on a device that is potentially vulnerable. Computers or phones could obtain a virus if the wrong link is clicked, and there are even some crypto exchanges that have been hacked or gone bankrupt.
A second type of digital wallet is a hardware wallet, otherwise known as a cold wallet. Hardware wallets are physical devices that hold your private keys completely offline. They’re designed as the safest way to store your private keys since they require you to press actual buttons on the device in order to transfer them. In this way, they’re unhackable, since no malicious party is capable of having your physical device in their hands, regardless of how good their digital attack is.
Hardware wallets can be attached to an online device when they’re ready to be used, and are normally compatible with an easy-to-use interface on your phone or computer. While software wallets are typically free to install, hardware wallets require an upfront purchase, normally somewhere between $50-$200.
The main benefit in using a hardware wallet is its security. The owner of the device has their private keys stored offline, and is 100% in control of their funds. However, this also requires a certain level of responsibility not everyone is willing to accept. If the user misplaces their seed phrase / private key, or allows a malicious 3rd party to get their hands on it, their funds could be lost forever. Hardware wallets also require an extra step when wanting to send or trade funds.
Essentially, software wallets are free and convenient, but can be more vulnerable if you don’t choose the right custodian. Hardware wallets are more secure, but require more responsibility and hands-on maintenance.
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