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Someone in one of the tech communities where I’m a member gave her crypto wallet passphrase to a random stranger in the community to help her with a crypto transaction she was finding difficult to execute herself. As you may have rightly guessed, her crypto wallet filled with cryptocurrencies worth thousands of dollars was emptied into another untraceable crypto wallet! We were all livid.
Why on earth would she trust a complete stranger with something as confidential as her Bank Verification Number? She replied that she sincerely didn’t think one could perform transactions on her crypto wallet with just her passphrase. This article aims to explain the different types of crypto wallets and how to use them so that you won’t make the type of disastrous mistake she did.
But before we get into it, What is a crypto wallet and why do you need one?
A crypto wallet can be viewed as your bank account, only it stores your cryptocurrencies rather than fiat currency. If you don’t already own one, below are some reasons why you need a crypto wallet:
1. For both local and international digital transactions: Some companies and entrepreneurs sometimes request to be paid in cryptocurrencies for their products and services. Cryptocurrencies also facilitate international transactions as it mitigates the need for a third party such as bank regulations which can make international transactions unnecessarily slow and difficult. You can pay for goods and services you purchase locally, send and receive money internationally faster and easier with cryptocurrencies and to effectively do this, you need a crypto wallet to hold the Cryptocurrencies.
2. For crypto trading: Some people take advantage of the price volatility of cryptocurrencies by buying when they're low in price and reselling for a profit when it becomes high in price. To be able to efficiently do this, one must have a crypto wallet to hold the Cryptocurrencies which they buy or sell.
3. For the use of other blockchain applications/website: To successfully have access to and use some blockchain applications/websites, one needs to have a crypto wallet which will be directly linked to that particular website/application. A clear example is the use of the Mirror writer's platform.
PUBLIC KEYS, PRIVATE KEYS AND MNEMONIC KEYS:
Every crypto wallet comes with public keys, private keys and mnemonic keys. To easily understand this, consider this analogy: the public key is like your home address. Say someone wants to send you a present, you’d give them your home address for the present to be delivered to you. The public key is like the home address of your wallet, it is your wallet address, you use it to receive and send out cryptocurrencies. It’s not private, you can give it to anyone who wants to send you some cryptocurrencies.
Now imagine if the delivery man opens your front door and delivers your present right inside your living room! I’m sure you’d call the cops. How did the delivery man get hold of the key to your front door? In crypto wallets, your private key is like the key to your front door, it is private to you. Giving it to someone else means you’ve given them access to everything in your wallet including your cryptocurrencies.
Both the public and private keys looks like a combination of a string of letters and numbers (9j6xT77oX...)
The mnemonic keys, otherwise known as a passphrase, secret phrase or seed phrase is like your purse where you keep your front door key and ID card (which contains your home address), it holds both your public and private keys. It is also private to you and you have to keep it safe because losing it means totally losing access to the crypto wallet altogether.
It is usually a string of 12 or 24 non-related words (jug, which, tavern, alarm...)
TYPES OF CRYPTO WALLETS
Cold/Hard wallets: Cold wallets which are also known as hardware wallets or cold storages are physical devices that store cryptocurrencies completely offline. They are mostly portable and may look like USB drives. You have to manually connect a cold wallet to the internet to make use of it for transactions. It also gives you full ownership and control over your private keys and encryptions. So while it may be secure, it is less convenient. Cold wallets help protect one’s cryptocurrencies from hacking and online attacks, but you can also risk losing your cryptocurrencies if you misplace the device.
Hot/Soft wallets: Hot wallets are digital and software based, meaning that they can be installed and used on your mobile device, computer or browser. Hot wallets are always connected to the internet and could be vulnerable to online attacks –which could lead to loss of cryptocurrencies, but it makes crypto transactions faster and easier.
There are 2 types of hot wallets and they’re mostly offered by crypto exchanges. Before we take a look at them, we have to understand what crypto exchanges are.
SO WHAT ARE CRYPTO EXCHANGES?:
They are basically digital marketplaces where cryptocurrencies are traded and exchanged. There are 2 major types of crypto exchanges which are:
Centralized exchanges: These are crypto marketplaces built by private individuals or companies to act as an intermediary (third party) that helps people store their crypto assets and regulate transactions for a fee. These exchanges are mostly regulated by the government and other authorizing bodies of a state. Good examples are Binance and Kucoin.
Decentralized exchanges: In this type of crypto marketplace, trade/transactions are governed by automated procedures conducted by a smart contract. What this means is that people have full regulation/control over their trades and transactions. There are no intermediaries or regulations from higher authorities. Good examples are Trust wallet and Metamask wallet.
THE TWO TYPES OR HOT WALLETS
Custodial wallets: This is one of the two types of hot wallets and it is usually offered by centralized exchanges. As in the name, when you open a custodial wallet, it means you’re leaving the ownership and control of your private keys and encryptions in the custody of the exchange trusting that they’ll keep it safe. This means that you don’t have full control of your crypto wallet and cryptocurrencies. You won’t be given the passphrase or private keys of the wallet. However, they’d require you to do a Know-Your-Customer (KYC) verification to ensure security.
Advantages:
1. Safety of private keys/passphrases: There is a lower chance of losing the wallet since its private keys and encryptions are safely kept in the custody of the exchange. One can always request for a change of password by contacting the exchange's customer support in case they've previously misplaced the password to their wallet.
2. Regulations: Since this type of wallet is mostly offered by centralized exchanges which are regulated by the government and other authorizing bodies of a State, you can hold them accountable in case there's a breach of your private data leading to subsequent financial losses by suing them and bringing them under the weight of the law.
Disadvantages:
1. Lower security: The centralized exchanges can be hacked and the private data (names and private keys) of its users tampered with, leading to serious financial losses.
2. Higher transaction fees: Transaction fees are high because you have to pay the “custodian” which is the exchange for helping you with the regulation, security and execution of transactions.
3. Slower transaction processes: Transaction processes are slower because you have to wait for the centralized exchange to sign and approve each transaction. Though these are all parts of their safety procedures.
4. Regulations: Through regulatory laws, the custodians have the right to lock a wallet, report accounts, pend transactions etc. especially if they believe the wallet is engaged in fraudulent activities. Other times, the government of a country can ban cryptocurrency trading which affects the operations of the exchange in a particular country. All of this can be distressing to a user of a custodial wallet.
Non-custodial wallets: This is the second type of hot wallets and it is usually offered by decentralized exchanges. This wallet gives you complete ownership and control of your wallet’s private keys, passphrase and encryptions. During the registration process of opening this wallet, you’d be given your passphrase with a strict warning to keep it safe. Kindly adhere to the instruction and don’t share the passphrase with anyone, as failure to do this may lead to loss of the wallet and the assets in it.
Advantages:
Non-custodial wallets mitigates the shortcomings of custodial wallets by totally eliminating the need for a third party. This in turn leads to:
**1. Lower transaction fees
- Higher security (from fraud/hacking)
- Faster transaction processes etc. **
Disadvantages:
1. Loss of private keys/passphrases: People tend to forget, misplace or entrust their private keys and passphrases to other people who may use it to steal the funds in the wallet.
2. No regulation: Since there is no regulating body governing the transactions carried out with non-custodial wallets, nobody is to be held accountable in case of scams, breach of privacy and subsequent loss of assets.
MORE INSIGHTS ON WALLET ADDRESSES
Simply put, a crypto wallet address is just like your bank account number. Now imagine you live in Nigeria and someone wants to send you 100 dollars, it would be wrong to send them your normal Nigerian naira account number. You’d have to create a dollar account to receive the money successfully.
This is the same for cryptocurrencies, every cryptocurrency has their unique wallet address. It’ll be an error to send ETH to a BTC wallet address, you may totally lose your crypto if you do that so you have to be careful. (remember the delivery man analogy? If you give someone else’s address to the delivery man, you may never get your package).
The good side is that both centralized and decentralized exchanges offer a number of wallet addresses for many cryptocurrencies once you register on the exchange. You don’t have to manually create wallet addresses for the different cryptocurrencies you have. All you have to do is search for the cryptocurrency on the exchange, click on it and copy its unique wallet address.
CONCLUSION
The choice of wallet to use is completely up to you. Consider the advantages and disadvantages of the different wallets and then choose the one that works for you. Though it is advisable that beginners use the custodial wallet. Advanced cryptocurrency traders use a combination of both cold and soft custodial and non-custodial wallets.