CryptopediaHow does a crypto wallet work? EXPLAINED

How does a crypto wallet work? EXPLAINED

If you want to own cryptocurrency at some point understand that in this space, you ARE your own bank. There are no age-old institutions bound by law to hold your cryptocurrency for you in an account that will always be under your control. Although let’s be honest, any money you have in your bank account is subject to your country’s laws and can be frozen or confiscated without your consent at any point in time anyways. So how does a crypto wallet work?

Thankfully, there’s been this great invention called a cryptocurrency wallet that, for the first time, allows you to be able to store your property somewhere where only you have access to it. Banks can be frozen, and assets can be seized or repossessed but if done right, no one can take your cryptocurrency. That being said, at some point, you’ll need to eventually set up your own cryptocurrency wallet. Though before you do that, wouldn’t it make sense to understand what options you have in terms of wallets and 

What a crypto wallet actually is?

How does a crypto wallet work: Understanding the best option for you will help prevent any issues in the future and understanding how these wallets work will make the process of sending and receiving cryptos much easier. It can be super satisfying once you successfully make your first transaction and even more so when you fully understand what’s happening along the way. If you were to take a look at the wallet you carry with you every day there are a couple of noticeable characteristics that you can easily identify regardless of the design or quality. 

Wallets are simple items, first of all, they are physical objects that are conveniently sized allowing you to take them with you anywhere you go. And secondly, they have pockets or compartments where any currency or cards can go into allowing you to take your money with you anywhere and spend it quickly, though if you were to lose your wallet… unless you or a good samaritan are able to find it, it’s unlikely that you’ll get it back, at least with the money still inside. This is why it’s common best practice to not keep large amounts of money in your wallet but instead use a bank, a trusted third party, to hold onto the rest of your funds for you. 

Difference between regular wallet & crypto wallet

There are a few key differences that separate a cryptocurrency wallet from a regular wallet right out of the gate. Apart from the obvious aspect of physical storage. With a regular wallet you could store Euros, or Yen just as easily as you could American or Australian Dollars. A cryptocurrency wallet on the other hand works a little differently and it forces you to be a bit more specific. Actually a lot more. 

How does a crypto wallet work: Cryptos like Bitcoin and Ethereum each have their own what’s called ‘blockchain network’. Think of a blockchain network as a highway along which all of the coins can travel along. Any Bitcoin that’s sent travels along the Bitcoin highway and any Ethereum sent travels along the Ethereum highway, the highways do not intersect and coins cannot travel along other cryptocurrency highways. As a crypto holder, you need to have separate ‘wallets’ for each ‘highway’ or blockchain network of the cryptocurrency that you own or want to receive. This is important to make note of and will become clearer as you understand the concept of cryptocurrency wallets. Instead of a physical or even digital object, I want you to think of cryptocurrency wallets, from here on out, as interfaces that connect you to a blockchain. 

How does a crypto wallet work? What’s beautiful is that, to understand the workings of a cryptocurrency wallet, you don’t have to fully understand the concept of a blockchain. We’ll leave that for another article. Apart from this, the way transactions are handled also changes. When you use a normal wallet, its function is limited to holding your currency. When you need to transact, you remove the money and then pay externally. Using a crypto wallet, everything is done in-wallet with the input fields the wallet provides you. Your wallet will be acting as both wallet AND bank depending on which ones you elect to use. Cryptocurrency wallets operate through the use of what’s called an address, more specifically multiple addresses. Think about where you currently live. You probably have an address right? That address isn’t secret, it’s on the map, and anyone who wants to visit you can do so by looking up your address. If you want a friend to come over, you give out your address and if you want to receive a package you provide that address, or maybe for mail you use a P/O box instead. Either way, any incoming visits or shipments all arrive through the use of your Public ‘Home’ Address. 

Now to keep out any unwanted visitors you probably have a lock on your windows, your doors, really anywhere you don’t want others to be able to enter from. A lock on the front door is the most common and normally we’d keep it locked through the use of a key. You could even use a door lock with a passcode or if you were cool enough, a swipe lock with a card like in a hotel. When it comes down to it, this key, card, or passcode you have to open your door IS kept private. It’s a Private Key. So I just explained exactly how cryptocurrency wallets operate. 

How does a crypto wallet work?

Each time you do what’s called ‘creating a wallet’ for a specific cryptocurrency, that cryptocurrency blockchain assigns you what we’ll refer to as an ‘account’ with two addresses. The first is a Public Address, where everyone can locate you to metaphorically ‘visit or see your account and more importantly, send you cryptocurrency. The second address the blockchain gives you is the key that will give you access to that account, called a Private Key. 

Remember when I said to think of a cryptocurrency wallet as an interface that connects you to a blockchain? These addresses you receive when creating a new wallet don’t come from the wallet provider itself, and they aren’t located with the wallet provider either. A cryptocurrency wallet simply relays information to and from the blockchain and displays it to you through a user interface. When you use a cryptocurrency wallet, you are simply able to ‘open up an account with that blockchain and interact with it by using the two addresses you are given regardless of the type or brand of wallet. 

In cryptocurrency, the Public Address is used to receive crypto or can be looked up to see where transactions came from or went. The Private Key sometimes referred to as Private Address, is used to gain access to that wallet account on the blockchain and send cryptocurrency from it. Having the Private Key is what gives you ownership of the wallet, just like owning a house key gives you access to the house. It’s not something to be shared online or with anyone else but yourself and perhaps close family in case of emergencies. 

How does a crypto wallet work? I hope you’re starting to understand now how a cryptocurrency wallet gives you full ownership of your funds. Unlike a bank account where your money resides with the bank in what’s technically their system through an account that you have been given access to, in cryptocurrency your money lives ON the blockchain and can only be accessed by the holder of the Private Key. This is why I emphasized the fact that your wallet information doesn’t reside in the wallet itself. It doesn’t matter if the Cryptocurrency Wallet Provider or App goes down because your money was never with the provider or on the app, to begin with, it was always within the account on the blockchain. 

How is crypto price determined?
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Crypto wallet benefit

How does a crypto wallet work? What’s cool is that now you can simply take your Private Key and import it into any other trusted wallet software and it will interact with the blockchain for you and bring up the interface with your Public Address and account balance. For those of you who are very into privacy, yes it would be cool if you didn’t even have to rely on a piece of wallet software to interact with the blockchain, and guess what, you don’t actually have to but in that case, you’d need to brush up quite a bit on your programming knowledge. 

For that reason, Crypto Wallets are often seen as a necessary interface tool for everyday people like you and me to access crypto funds. Now, the way I access my funds may be different than the way you go about doing so. We’ll both be using wallets though so why don’t we go over a few of the options we have when it comes to which type of cryptocurrency wallet to select. If you’ve read our other article, ‘Why Cryptocurrency’ you probably have an idea of what your goals are for buying crypto or you’re on your way to figuring it out. 

The reason you should know your why in cryptocurrency prior to selecting a type of wallet is because you need to make a choice between whether you’ll be using what’s called a HOT wallet or a COLD wallet as far as what would best suit your needs. I’ll make suggestions where I can but ultimately, the choice is up to you. First, though, let me explain the differences between these two wallet types. 

Difference between HOT & COLD crypto wallets

How does a crypto wallet work? In Short, the difference between HOT & COLD wallets – is the method they use to interact with the blockchain. Hot wallets are usually software applications and they verify your Private Keys with the blockchain directly over the internet. They are easier to set up and faster to use. Though they could be susceptible to an attack if the wifi connection you use to access your wallet is not secure. Whereas cold wallets are more often devices that, while still technically connected to the internet during use, perform what’s called transaction signing on the cold wallet device itself. 

Transaction signing is a way to prove that whoever creates the signature, also owns the wallet because the transaction can only be signed with the private key. The device then broadcasts the signed transaction over the network connection. What happens here is your private key is never exposed to the internet, it stays on the device and only the signature is broadcast. 

What this does is add an extra layer of security and ensure your private details will stay private. If cold wallets ensure that your privacy stays private then why would you not use them all the time?

Why would you ever use a HOT crypto wallet?

 Well, this depends on the situation. Hot wallets are great for quick access to funds and can be accessed right from your internet browser. You can send and receive funds instantly so they are a much more convenient way to access your cryptocurrency. Cold wallets require a secondary device, then for you to connect that device, unlock it, and then approve each transaction manually. Safer, yet there are more steps involved. As a result, each has its pros and cons and this is why you may access your funds in a different way than someone else, it all depends on your cryptocurrency needs. 

Pros and Cons

As mentioned, cold wallets take the form of hardware, these are small, physical devices used solely for the purposes of securing your crypto. The most popular ones around are the ledger nano, which sort of looks like a USB stick, and the trezor, which resembles a stopwatch.

Hot wallets are software applications. Which often take the form of desktop apps, browser extensions, or phone apps. This means you should trust the software developer or at least make sure it’s been thoroughly tested and withstood the test of time. For example, a popular wallet called ‘Metamask’ functions as a browser extension for the Ethereum and Binance smart chain. It’s been used for years and recommended by many as a good wallet solution. You’ll probably find that it’s easiest to use a combination of both types. 

One can act as your secure safe in the form of a cold wallet. This one is for large amounts or amounts you won’t need to access often. The second wallet can be for crypto that you plan to trade with or at the very least access often to the point where quick access through a phone or desktop wallet would come in handy. As intimidating as it might’ve sounded, being your own bank isn’t so hard once you understand what crypto wallets are and which types to use in certain situations. 

I mentioned before how a crypto wallet works that if you were to lose your regular wallet, it’s unlikely you’ll ever see the money that was in it again. Well with crypto wallets, regardless of whether you’re using a hot wallet or cold wallet, there is a security feature called a ‘back-up phrase’ or ‘seed phrase’. Recording this phrase somewhere safe is something that you’ll be prompted to do whenever you create a new wallet and I’d recommend you actually do it. 

Related: How is crypto price determined?

What crypto wallet seed phrase does?

What this phrase does is ensures that even if you forget your private key or lose access to your device entirely, you’ll still have a way to access all of the funds inside of the wallet again. It’s a great safety feature that you won’t care much about until the day you lose access to all your files or your computer suddenly dies, and then you’ll be extremely glad you took the time to write down your seed phrase.

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