Introduction to Bitcoin Wallets
Table of Contents
- Bitcoin wallets generate and store a user's keys, allowing them to easily send and receive bitcoin, track their transaction history, and check their balances.
- Wallets come in the form of hardware devices, software applications, and online, custodial services.
- Hot wallets connect to the internet, offering easy access. They should be used to store small amounts for spending.
- Cold wallets offer greater security by staying isolated from other devices and the internet. They should secure larger balances that do not need frequent access.
What Is a Bitcoin Wallet?
A Bitcoin wallet is a device or service used to secure and manage bitcoin. There are many different types of wallets, but all wallets perform two main functions:
- Storing the user’s public and private keys. A public key is used to receive payments while a private key is used to send payments
- Facilitating transactions, i.e. the receiving and sending of bitcoin.
All bitcoin is recorded on Bitcoin’s blockchain. A wallet does not physically or digitally store a user’s bitcoin, but stores a user’s private keys and public keys. Private and public keys are associated with a specific piece of bitcoin, allowing the user to transact on the Bitcoin network, prove that they are the initiator or receiver of a transaction, and check their balances.
What Are the Different Types of Bitcoin Wallets?
Wallets are differentiated by two defining characteristics: whether they are a hot wallet or a cold wallet, and whether they are custodial or non-custodial. Different wallets are best for certain purposes; a hot wallet can facilitate more frequent transactions, while cold wallets provide better security for long-term storage. Choosing a wallet depends on how often a user plans to move bitcoin, and requires making a trade-off between security and convenience.
Custodial Cold Storage
Non-Custodial Cold Wallet
Custodial Hot Wallet
Non-Custodial Hot Wallet
A hot wallet is the most convenient wallet used, and Web, mobile and desktop wallets are all hot wallets. A hot wallet is always connected to the internet, and allows a user to send and receive bitcoin on demand.
Because hot wallets are connected to the internet, the wallet is vulnerable to attack by hackers or malware. Thus, keeping a large amount of bitcoin in a hot wallet is considered a poor security practice. A hot wallet can be custodial or non-custodial. A non-custodial hot wallet circumvents security concerns associated with a third-parties vulnerability and practices, but places the security responsibility on the user.
However, not all users want to hold responsibility for the security of their keys. In that case, using a hot wallet with a custodian, like an exchange or Bitcoin custodial service, is the most secure solution.
Exchanges will often keep a small amount of bitcoin in a hot wallet in order to offer immediate withdrawals to its clients, while keeping the majority of its bitcoin offline in cold storage.
Unlike hot wallets, cold wallets generate and store a user’s private keys in an offline environment, known as cold storage. Certain cold storage solutions allow transactions to be created and finalized without being connected to the internet.
Because they are never connected to the internet, the threat of an attacker gaining digital access to a user’s keys is significantly reduced. The only way an attacker can access your private keys is through physical means. Cold wallets are always non-custodial, although cold storage is a common security practice of many exchanges and brokerages.
However, cold storage is not without its drawbacks. Because it is a non-custodial solution, the user is completely responsible for the security of their keys. If their device is stolen and they lose their mnemonic phrase, they have no third party to lay a claim with and no way to recover their funds. In contrast, with a custodial wallet, like a web wallet used on an exchange, funds can still be recovered if a user loses their device or password.
A custodial wallet is a wallet wherein the user’s private keys are held by a third party, such as an exchange. The third party has full control over the user’s funds, while the user only has permission to send and receive bitcoin.
The third party is responsible for providing a backup to the wallet in case the user forgets their login information. A custodial wallet is subject to the security practices of the third party, which reduces the users responsibility, but creates an increased risk to the seed phrase and the keys stored by the wallet if the third party is hacked.
Non-custodial wallets give the user full control over their funds and the associated private keys. By using a non-custodial wallet, a user is their own bank; they can initiate transactions, and are responsible for the security of their wallet, including protection of their seed phrase, which can be used to restore their wallet if it’s lost or compromised.
User is responsible for security
User decides the fee rate
The most commonly used form of cold storage is a hardware wallet. A hardware wallet is a small, portable device that keeps a user’s keys isolated from the internet at all times. To transact, a computer and the manufacturer’s application are required in order to keep the private keys offline.
Hardware wallets are immune to the digital attacks a hot wallet is susceptible to. A hardware wallet also ensures that a user’s private key is never given to a third-party wallet provider or software that could be vulnerable to a virus attack or theft. Hardware wallet software is often open source. This allows users to validate the entire operation of their device and easily create a hardware wallet for themselves.
A Bitcoin wallet is necessary for storing private and public keys, which are used to send and receive transactions. Different types of wallets of varying levels of security and ease-of-use.
If security and long-term storage is a user’s primary goal, then a cold wallet is a better option than a hot wallet. For users who want to make frequent and fast transactions, without being solely responsible for the security of their wallet and seed phrase, a custodial hot wallet may be their preferred option. Choosing the wallet type that best meets the users needs is essential to being a thoughtful and secure bitcoin holder.