When we talk about “traditional” wallets, we simply refer to the object we use to store our money in the form of coins, banknotes, or even debit/credit cards. However, it doesn’t seem to make much sense to talk about wallets when it comes to cryptocurrencies since one of their main characteristics is their digital nature. So, what is a cryptocurrency wallet?
As we just explained, cryptocurrencies don’t have a physical form; they are simply a balance recorded in an account. Access to that account is done through a pair of public and private keys that only the owner knows. With those keys, the user can transfer the money to any other account, whether it’s to purchase goods or services or to send money remittances.
Those keys are what the owner must protect because they are the only access point to the cryptocurrency balance. Without those keys, it’s not possible to make any transfers or payments, effectively making the cryptocurrencies disappear from the system. Therefore, a wallet is the physical or virtual device that allows us to store those keys and access them when we need to make any kind of transaction.
Security in cryptocurrencies
Now that we have defined wallets, let’s talk about security. We already mentioned this issue when explaining how DLT networks work, and we talked about two different types of security. On one hand, there is the security inherent to the network (which depends, among other things, on its consensus algorithm). On the other hand, we have the security of accessing the system, and this is where wallets come into play. But why is this security so important?
Remember that cryptocurrencies, for the most part, operate under a decentralized system. This implies that there is no institution or person managing access to the system, other than the user themselves. This has its advantages (lack of intermediation, absolute control of your own money, anonymity within the network, etc.), but it also has its disadvantages.
Among these disadvantages, one of the main ones is that all the responsibility for accessing and controlling the balances rests on the user. In fact, in case of problems such as password loss, there is no one to turn to for assistance. Currently, this problem affects 20% of issued bitcoins, which are in accounts with lost keys. This means that they cannot be accessed or operated with and are effectively out of circulation.
For all the reasons mentioned above, wallets are an essential element when it comes to ensuring security in cryptocurrencies. However, protecting access to the accounts is not their only function.
Functions of Wallets
Wallets serve to protect access to cryptocurrency accounts. Additionally, each cryptocurrency has its own network, which can make wallet setup challenging. This is why the function of wallets has been growing in importance in recent years. In fact, various password recovery systems, interoperability with different networks, etc., have been developed. Let’s now explore all the possible functions a wallet can have:
- Accessibility – The main function of wallets is to protect and enable access to our cryptocurrency accounts. The format of the wallet will determine the access to the account. In fact, wallet categories are differentiated precisely by this element. Depending on the chosen wallet, accessibility will vary.
- Password recovery systems – Keywords, personal questions, a limited number of attempts, etc. These are some of the different ways wallets add an additional layer of security to the keys and allow us to recover them in case of forgetting. However, it is important to note that the more secure the wallet, the more careful the user must be. There have been cases where users lost their wallet password, and if the wallet is highly secure, the funds become inaccessible.
- Multiple currencies – There are wallets designed exclusively for a single cryptocurrency, while others have the option to store multiple currencies.
- Ability to transact – Wallets can be used solely for storing access to our accounts or can also facilitate transactions. By having the keys to our account stored, we can transfer or receive balances from other accounts and check the current balance at any time. This is done through a digital signature, which is what the network uses to identify the account owner.
Types of Wallets
Based on what we’ve discussed so far, we know that wallets may appear simple, but they can fulfill various functions. The complexity of wallets in performing these functions will be the main determinant of their price and, above all, their security. Generally speaking, we can identify two main groups of wallets based on their accessibility.
“Hot wallets” refer to wallets that are 100% online. These wallets are accessible from anywhere with an internet connection, and their main advantage is convenience. Hot wallets can be further divided into two types:
- Hosted wallets: Hosted wallets are owned directly by the platform or exchange where the cryptocurrencies are purchased. This option is quite common, but it has the disadvantage of lacking real independence between the platform and the custody of funds. This means that if the platform is hacked, users’ funds will be fully exposed. In fact, there have been multiple cryptocurrency thefts through this method.
- Online wallets: The other type of online wallet. In this case, the custody of funds is completely independent of the platform, providing greater security.
Online wallets are generally less secure than physical wallets. They are exposed to potential hacks, although the level of security may vary depending on the service provider. However, they are the most convenient type of wallet. You only need an internet connection to access your funds from anywhere, and there is no physical device that can be lost.
On the other hand, there are cold wallets, which are wallets based on a physical device. In comparison to hot wallets, they offer higher security but less convenience. As always, the choice depends on the type of usage intended. Similar to hot wallets, there are two types:
- Physical wallets: This type of wallet is similar to a USB device. It has a security system that prevents the keys from being recorded on a computer, and access is granted through a PIN code. Obviously, forgetting this PIN code would result in the loss of access to the funds. Therefore, the high level of security provided by these devices can work against the user if they are not careful. This type of wallet is the most secure but also the most expensive.
- Paper wallet: It is as simple as a document that displays our keys with a QR code in case we want to manage them from another wallet. This type of wallet is perfectly protected against any type of hacking, but precisely because of this, its use is very limited. As can be seen, physical wallets are the most secure in the market, although they are also the most expensive. However, that does not mean that other types should be dismissed. It depends entirely on the use and purpose of the wallet.
Which wallet is better?
With all the above in mind, we can now decide which wallet best suits our needs. Cryptocurrency trading platforms often offer a free wallet service. If we don’t want to complicate things, this can be an option to consider. However, it is important to note that our money would be under the control of an unregulated entity. Without physical support, we would be exposed to hacker attacks on these platforms, which could result in the loss of our entire investment.
Therefore, if we want to avoid these risks, we will need to acquire a wallet that we have control over, and its features will depend on our needs. Obviously, the accessibility to the funds will be inversely proportional to the level of security obtained. Therefore, a physical device will provide more security than a cloud-based wallet, but it will also have limited access to the funds. We should consider the following questions:
- Do we want to operate with different cryptocurrencies?
- How frequently will we be moving the funds (short-term, medium-term, long-term operations)?
- How much money will we have invested in cryptocurrencies?
- What type of access do we want for our wallet?
- What type of activity will we be conducting: storing cryptocurrencies or exchanging them?
Once we have clear answers to the above questions, it will be much easier to determine which wallet suits us best.
In conclusion, we can say that there is no foolproof system, and even with the most secure wallet, we still assume the risk of key loss. Depending on our characteristics as investors, we should choose a wallet that suits us. Additionally, risks can be mitigated by using multiple wallets, regularly checking passwords, etc. This way, we can minimize risks and operate with cryptocurrencies in a much safer manner.