What is a cryptocurrency wallet?

Definition

Cryptocurrency wallets let you receive, spend and monitor your assets securely on a software program by interacting with the blockchain. It is the single medium of interaction between the user and different cryptocurrency blockchains.

All that exists is the transaction history recorded on the blockchain.
Behind the scenes, the sender proves to the network that he is the owner of a cryptocurrency account through cryptography.
The sender needs to sign off a transaction, by providing both the blockchain public address (where the funds are stored) and the associated unique private key.

After the network verifies the pair is correct, the transaction is recorded, and the two public address balances are updated.

Technically speaking, no physical object or digital file “stores” Bitcoin or any cryptocurrency.

  • You cannot say “this computer or this file has bitcoins”.
  • But you can say “this computer or this file stores a private key that gives me access to bitcoins”.

Here's a recap of what is required to send a digital asset:

Types of wallets

Now that we understand what wallets do and how they work, let’s review their categories:

There are three different types of wallets, all of which gives a different level of control, security and user experience:

  • Online wallets and exchanges: Third party holds private keys. The user therefore holds an IOU, a promise of payment when requested.
  • Hot wallets: Private keys are stored locally. The holder is in control, but vulnerable to physical and online attacks.
  • Cold wallet: Keys are stored in an offline environment. Safe from online threats, still vulnerable to physical attacks.

Online

When storing your cryptocurrencies on an online wallet, such as an exchange, you do not own them per se. As such, you hold an IOU from a third party: an “I owe you”. It is the promise that a third party will send you your coins when you request them to do so.

In the cryptocurrency world, either you have full control over your private keys, or you trust a third party to store them.

Bitcoin is a technology breakthrough because it allows users to hold wealth by restricting the access to their private keys, without the need of an intermediary.

Trusting a third party in cryptocurrency is similar to the current centralised fiat economy.

WARNING! You do not own crypto-assets stored on exchanges and online wallets, you only own a promise that a third party will give you back your funds – nothing less, nothing more.

Hot

Hot wallet owners have full ownership over their digital money, as they do not require to trust any third parties. As such, private keys are stored locally rather than on a middleman’s system.

However, although hot wallets enjoy improved safety features, a hot wallet (desktop or mobile) is still vulnerable to hackers and viruses because they are connected to the internet.
An attacker can still take hold of your private keys if they have not been firmly secured on your device. To summarise, your digital assets in a hot wallet are as secure as the device that store them.

Cold

Finally, cold wallets store cryptocurrencies and assets in an “offline” system also known as “air-gapped”. As they are never connected to the web, it makes it impossible to compromise them online (if the system has been correctly set up). However, they are still vulnerable to physical threats.

This level of security is possible only when private keys are generated and stored in an offline environment.

Cold wallets are the most secure way of storing crypto-assets and generally come as a hardware device (USB stick or air-gapped laptop) or a paper wallet.