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How do cryptocurrency wallets work?

What is a cryptocurrency wallet?

A cryptocurrency wallet is a secure digital wallet that can be used to send and receive cryptocurrency payments. As with most things related to digital currencies, the reality is a little more complex

A cryptocurrency wallet is a digital wallet for holding digital currency. Cryptocurrency wallets rely on cryptography for security.

Public and private keys

Public key cryptography (also referred to as asymmetrical cryptography) is any cryptographic system that uses pairs of “keys”. A key is a piece of information that unlocks or decodes a cryptographic algorithm.

There are two types of keys: public keys, which can be known by many people, and private keys, which are only known to the key owner. The use of public and private keys accomplishes two functions – authentication and encryption. Authentication is where the public key verifies that the message was sent by the holder of the paired private key. Encryption is where the paired private key holder (and them alone) can decrypt a message encrypted with the public key.

Public and private keys in a cryptocurrency wallet

Now you understand more about public and private keys, let’s look at how this works in a cryptocurrency wallet. Obviously, there is no cryptocurrency actually stored in an electronic wallet.

In the case of Bitcoin, the cryptocurrency is stored and maintained in a publicly available ledger. Every piece of cryptocurrency has a private key. With the private key, it is possible to write in the public ledger, effectively spending the associated cryptocurrency.

Your wallet stores your private and public keys. This allows and facilitates the sending and receiving of coins. Furthermore, it also acts as a personal ledger of transactions.

Features, characteristics, and types of cryptocurrency wallets

Cryptocurrency wallets come in different forms with a range of features and benefits. Here are the main types of crypto wallets with brief explanations.

Multi-currency cryptocurrency wallets

This is a wallet that supports different types of cryptocurrencies that can be “stored” at the same time.

Software cryptocurrency wallets

This is the main type of wallet – as you might expect with a digital currency. It’s worth briefly considering the different types of software wallets. They come in many different forms, such as:

  • An application installed locally on a computer or device (smartphone or tablet).
  • A web-based application. Note that some web-based wallets use additional security. You may have come across two-step verification like Google Authenticator. The main benefit of this additional authentication is it prevents hackers from using keystroke logging to try and gain access to the wallet.
  • A cryptocurrency exchange. An exchange links the user’s wallet to the exchange’s centrally managed wallet. Any trades are written in the exchange’s ledger as an off-chain transaction. When a user enters their cryptocurrency into the exchange or takes it out of the exchange, then the transaction is written onto the blockchain.

Hardware cryptocurrency wallets

It’s interesting that hardware wallets exist when you consider cryptocurrencies and the whole concept of a decentralised digital currency. A hardware wallet is a small digital device that can be plugged into a computer to be used to authenticate cryptocurrency transactions. The rationale is to provide added security. Some types of wallets require the user to physically press or touch the wallet in order to sign a transaction.

When the user of a wallet requests a payment, the wallet creates the transaction and provides a public key which is sent to the network. In effect, the signing keys never leave the wallet.

Watch-only cryptocurrency wallets

With a watch-only wallet, someone can keep track of transactions but transactions can’t be initiated since there is no private key stored in the wallet. The private key can be kept safe in another location.

Multi-signature (multi-sig) cryptocurrency wallets

This is a wallet where multiple users have to sign a transaction using their individual private keys.

Brain cryptocurrency wallets

A brain wallet requires the owner to remember the information required to regenerate the private and public key pair. This is often facilitated by the user memorising a mnemonic sentence.

Hot cryptocurrency wallets

This is a wallet connected to the internet that will allow cryptocurrency to be spent at any time.

Cold cryptocurrency wallets

This is a wallet not connected to the internet. To use a cold wallet (such as an unconnected hardware wallet), then it first has to be connected to the internet.

Deep cold storage cryptocurrency wallets

This refers to storing cryptocurrencies in cold wallets that were never connected to the internet or any kind of network.

Deterministic cryptocurrency wallets

With a deterministic wallet, a single key (or “seed”) can be used to generate an entire “tree” of key pairs. The single key serves as the “root” of the tree. The advantage of this system is if a hard drive becomes corrupted and a wallet is unrecoverable, a new wallet can be created using the same seed. All of the addresses and private keys from the old wallet will return.

Non-deterministic cryptocurrency wallets

With this type of wallet, each key is randomly generated on its own accord. Any backups of the wallet must store each and every single private key used as an address, as well as future keys that may have already been given out as addresses but which have not received payments yet.

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