Bitcoin was created to permit two parties using bitcoin wallets to confidentially exchange value directly with each other, without the need to rely on an intermediary. What that means is, unlike PayPal for example, two individuals can send each other funds directly – peer-to-peer. There is no middleman moving the funds from person A to person B, or taking a percentage of the funds for doing so. Before using digital assets for serious transactions, appropriate steps must be taken to select and secure a “wallet”.
The first thing to understand is that wallets do not actually store coins. A wallet is a software program that stores the public and private keys needed to receive or spend a cryptocurrency which creates a transaction. Private keys are long hexadecimal codes which are known only to you and the wallet. These codes must match with a public key in order to spend your funds. The underlying technology that records transactions is “blockchain”, a single, digital ledger stored in a distributed network.
We’ll use a comparison to explain how blockchain works to greatly simplify how it works. Imagine what happens when two banks process a transaction. Both banks keep their own internal ledgers to record customer balances. Both need to update their individual user account balances on their own internal ledgers when a request to transfer money from one customer to another is received. Banks spend a tremendous amount of time, effort and money to coordinate, synchronize, message, and check to ensure that each transaction is processed exactly as it should. Typically, the funds being transferred are held by the originating bank until receipt by the recipient account is confirmed by the receiving bank.
On the blockchain, a single ledger of all transaction entries is accessible by both parties exchanging funds. This simplifies the coordination and validation efforts tremendously. There is only one single version of records, not two completely separate, different databases that cannot be compared (like banks use). Furthermore, public key cryptography is used by this innovative approach to bookkeeping to achieve authorizations, balance verifications, prohibition of double-spending, delivery of assets, and the recording of transactions – all of which happens in near real-time at no cost. Cryptography ensures authorization and you need a private key to transact. This private key is so complex that it is essentially unhackable.
Every bitcoin wallet contains one or more private keys which are mathematically tied to related public keys, known as “addresses” generated by the wallet. This secret alphanumeric number is used to spend or send your crypto assets, and this is what happens:
- You want to send some of your bitcoin to me;
- You publish your intent to the bitcoin network by using your wallet to send to me a specific amount;
- Using both your private and public keys, a digital signature is created and sent to the network;
- All nodes (computers) scan the entire bitcoin network to validate that:
a) You have the bitcoin you want to send; and
b) you haven’t previously sent it to someone else;
- Once that is confirmed (usually 6 confirmations are needed), the transaction is included in a “block” on the blockchain;
- It is now recorded that you sent the bitcoin to my address and you can see this in your wallet;
- My bitcoin wallet receives and saves the private key associated with the bitcoin you sent;
- The transaction cannot be reversed or tampered with, it is permanent.
Importance of Private Keys
Since the private key is essentially the asset, as there are no physical digital coins, it stands to reason that protecting it is vital. Think of the private key as if it were a piece of gold. If a gold piece is stolen, lost, or otherwise removed from your possession, it cannot be recovered. Neither can a private key be recovered if it is lost, stolen, or sent to the wrong party. Your bitcoin wallet does not actually hold your bitcoin. It holds your bitcoin addresses, known as private and public keys which record all of your transactions, thus your balance.
Each public key (address) has a corresponding private key and, while the two are related, there is no way to figure out a private key by having the public key. It is necessary to use the public key (address) so others can send you bitcoin, similar to an email address. When you use the public key to send bitcoin, your private key “signs” the transaction, the bitcoin wallet creates a digital signature, which is sent to the network for validation. Everyone can watch bitcoin transactions as they occur.
Types of Bitcoin Wallets
Selection of bitcoin wallets depends on what you intend to do with your digital assets. Most cryptocurrency users have several, some being used for bitcoin, others specifically for certain altcoins, and still others that hold bitcoin in addition to altcoins. There are basically three different types of wallet applications, and five main types of bitcoin wallets.
- Full client – similar to a standalone email server, a full client wallet handles all aspects of transactions without relying on any third-party servers. Transactions from beginning to end are controlled by the user and this type of wallet is not for those new to cryptocurrency.
- Lite client – similar to a standalone email client which is connected to a mail server and gives access to a mailbox – like Outlook or Apple Mail, for example. You install the software on a device, use it to connect to Gmail or another mail server, and access your mailbox on that server.
- Web client – the opposite of “full client” this wallet relies completely on a third-party to handle all transactions and requires KYC verification. Similar to using Gmail’s online portal to manage your email, send and receive messages without using an email client like Outlook or Apple Mail.
- Online Wallet – this wallet runs on the cloud and can be accessed from multiple devices using an Internet connection. They are practical and convenient but are the most susceptible to theft or breach. Users of this type of wallet do not control their private keys – the wallet provider does.
- Mobile Wallet – an app that is installed on a smartphone and requires an account with the provider. While handy for small transactions, users do not control their private keys and the risks of losing assets are high.
- Desktop Wallet – an application downloaded and installed on a desktop or laptop that is accessible only on the device on which it is installed. Considered more secure than online or mobile wallets, but are only as secure as the computer on which it is installed. The user does control their private keys.
- Hardware Wallet – a physical USB drive device which stores private keys and can be used to make online transactions only when connected to the Internet. Kept offline except when in use, hardware bitcoin wallets are considered to be the most secure. The user has the ability to send and receive digital currency simply by plugging into an Internet-enabled device to authorize themselves. The user controls the private keys and they can be recovered if the device is lost, stolen or damaged.
- Paper Wallet – a physical copy of your public and private keys on a sheet of actual paper. Considered to be secure but great care must be taken to store physical paper for obvious reasons. The user controls the private keys but there is no recourse for recovery if the paper they are printed on gets lost, stolen or damaged.
Bitcoin Wallets Security
Selection of a wallet type to use depends on how you intend to use your crypto assets. If a wallet is connected to the Internet, it is considered to be a hot wallet. If not connected, it is a cold wallet such as hardware or paper bitcoin wallets. Regardless of which is used, security requires a healthy balance between keeping long-term assets cold, ready-to-use funds hot, and all cryptocurrency secure!
Use difficult to determine usernames and secure passwords, as well as two-factor authentication when possible. Select trustworthy wallet devices or providers and encrypt your wallet for extra safety. Whatever device your wallet is used on should be kept updated with the latest software, as your security often depends on the device as much as the wallet itself. Avoid keeping assets in exchanges online. While convenient, it is very hazardous and every major “hacker” incident involving Bitcoin has occurred on an exchange – not the Bitcoin network. There are numerous horror stories of lost funds due to exchanges that were closed, hacked, or just up and disappeared with users assets.
Backup your wallet by creating several copies of your software or seed phrases, and storing these copies in a safe location. Remember – your actual bitcoin assets are not kept in or on anything, only the private and public keys are recorded. Therefore, if you lose a hardware wallet, or your smartphone is stolen, or your desktop computer crashes – you can restore your recorded private and public keys using a backup. If your passwords are weak, your software is vulnerable, or you don’t have a backup, your investment will be lost forever.