Cryptocurrency wallet is an endpoint to the world of blockchain and Web3 technology. It allows crypto enthusiasts to store, send, receive and (in some cases) exchange their assets amongst each other.
While crypto wallets unlock a plethora of new opportunities in terms of security, transparency and censorship resistance, using them takes basic skills of crypto security and a high-level understanding of how blockchains work.
What are crypto wallets?
In general, crypto wallet is a software mechanism designed for storage, sending and exchanging cryptocurrency. At the same time, a crypto wallet is an address in blockchain associated with this or that keypair (private and public key). Just like a bank account, every wallet has its own balance, i.e., amount of units of this or that blockchain (BTC for Bitcoin, Ethers for Ethereum) stored on the wallet at the current block.
In blockchain, to transact, an owner of a crypto wallet authorizes the transaction with his/her private key. Once the transaction is authorized, cryptocurrency tokens are transferred from a balance of his/her account.
However, due to the nature of blockchain technology, the tokens do not come to the recipients’ wallet immediately. The transaction is added to a queue (called “mempool”); the recipient's wallet receives the coins with latency.
Unlike bank accounts, crypto wallets can be created in a few clicks in a zero-fee manner. Every user can create an unlimited number of wallets on every blockchain. Every crypto wallet has a unique address: for instance, a first-ever Bitcoin (BTC) wallet has “Bitcoin genesis” address 1A1zP1eP5QGefi2DMPTfTL5SLmv7DivfNa. Bitcoin wallets’ addresses can start with 1, 3 or bc1. Ethereum (ETH) wallets start with 0x; the genesis wallet address includes 0x, followed by 40 zeroes. Also, crypto wallet addresses can be shared as QR-codes.
What are public and private keys?
Public and private keys are two pivotal elements of crypto wallet cryptography (so-called public key cryptography).The public key is known publicly; it serves as an identification number required to identify this or that wallet within the blockchain. Private keys, on the other hand, should be kept secret: blockchain users need them for encryption and authorization of transactions.
On the majority of blockchains, wallet addresses represent the hashed form of the public key. The public key is a string of alphanumeric characters that looks like 2049 035D 01DD 1DF2 2F2F EC33 EFD6… and so on.
In blockchains, private keys can be compared to PIN numbers or passwords from email and social media accounts. A private key is also a string of alphanumeric symbols that cannot be hacked—for instance, D778FC48C8A32440DC8D13487CA8117CAF665CAD412F1C6074ACB487721BBF54.
Both private and public keys are generated automatically: private keys are therefore used to let the blockchain know that this or that owner has the right to authorize transactions from a certain account.
It is impossible to derive a public key from a blockchain address and to derive a private key from a public key. Every public key has its own corresponding private key.
What is a seed phrase?
A seed phrase is a sort of nucleus of this or that crypto wallet. It includes all the information about the addresses associated with a blockchain wallet: its transaction details, balance and so on.
Seed phrases consist of 12 English words: it is generated randomly and used to restore a crypto wallet when the keypair is lost. In this situation, it works like a key and lock at the same time. The order of words in seed phrases matters: when recovering a cryptocurrency wallet, you should enter them in the same order they were generated.
The wallet generates a seed phrase and displays it to the owner of the wallet. On major software and hardware wallets, one seed phrase is used to recover access from wallets on various blockchains, i.e., on Bitcoin, Bitcoin Cash and Ethereum.
What’s the difference between custodial and noncustodial wallets?
As you may see, the management of private keys and seed phrases takes responsibility and basic technical skills. As blockchain adoption accelerates, some services started offering key management services.
Custodial (or “centralized”) cryptocurrency wallets can be accessed by a login/password pair just like email or a digital bank account on PayPal and Venmo. This means that they control your keys and seed phrases - or at least store “your” coins on their addresses in blockchain.
Typically, such wallets are associated with large crypto ecosystems like Binance (BNB) or Coinbase. While using them, you can recover your wallet even without a seed phrase. Also, they are feature-rich: you can stake, exchange your tokens, trade with leverage or withdraw to fiat accounts.
However, the “not your keys, not your coins” rule works perfectly for centralized exchanges. Their teams can easily freeze your funds. Also, due to FATF rules, using top-tier custodial wallets is impossible without passing KYC checks.
Users of noncustodial (“decentralized,” “self-custodial”) are solely responsible for security and privacy checks. They can recover their wallets directly with seed phrases and private keys. Also, there is no need to register accounts and perform KYC checks.
However, if the seed phrase is lost, no one would be able to restore access to funds: they will be lost forever. As such, owners of noncustodial wallets should be super-cautious about key management and seed phrase security.
How to keep your seed phrase safe
At the same time, security management for noncustodial wallets (keeping seed phrases and private keys) relies on very simple rules.
Write it on physical device
Do not skip this step: write a seed phrase on paper or on a special metal plate (if you are using a sophisticated hardware wallet). Make some copies and keep all of them in secret places.
Avoid saving it on PC
Do not save your seed phrase in iCloud, “Saved Messages” in messenger; avoid sending it to yourself via email. Modern malware is able to find them wherever they are stored in digital form.
Do not put all your eggs in one basket
As with asset management, consider building a “diversified portfolio” of crypto wallets. It is better to store money not only in different assets, but also in different wallets, both centralized and decentralized.
Money loves silence
Last but not least, do not talk too much about your crypto assets and the ways you store them. Do not forget that every person interested in your seed phrase or private key on the internet is a scammer.
As a cornerstone element of public-key cryptography, a seed phrase is the essential instrument for recovering your crypto assets from noncustodial wallets. It includes 12 English words put in certain order.
Custodial wallets can perform key management on their own, but they control your crypto and, therefore, can freeze your coins at any time.