For most people the first step to acquiring cryptocurrency should be creating a wallet to store digital assets.
Why is it so important?
Well, “owning” cryptocurrency is somehow a misleading way of thinking about it.
When we talk about Bitcoin ownership we only mean that you have access to a secret number, commonly known as a private key, which can be used to mathematically prove that you have control of said Bitcoin.
Receiving bitcoins, and subsequently sending or storing them, involves mathematical steps involving private keys interacting with the blockchain. These steps are complicated with plenty of room for error, so we use Bitcoin wallets to manage keys in the background, which makes it easier and safer for users to receive, send, and store their bitcoins.
This article explains how Bitcoin transactions actually work and explains why we use Bitcoin wallets to manage our private keys and transactions, and describes common types of wallets. For more information, check out our guide to the best cryptocurrency wallets.
Table of Contents:
What is a Bitcoin transaction?
A Bitcoin transaction is the transfer of ownership of coins from one person to another. Transactions contain two types of information: input and output. A transaction input is where the sender uses their private key to prove ownership of an existing coin, allowing them to spend the coin. A transaction output is where the sender creates a new coin and locks its ownership to anyone who possesses a separate private key. Individual transactions can contain many inputs and outputs. All Bitcoin transactions are stored on the blockchain (which is similar to an online ledger).
Imagine that Alice owns the private key for a 0.08 BTC coin and wants to give Bob ownership of 0.06 BTC. Alice creates a Bitcoin transaction with three parts:
- Transaction input: Alice uses her private key to prove that she owns the 0.08 BTC coin and is authorized to spend it.
- Transaction output: worth 0.06 BTC, can only be spent by Bob’s private key.
- Transaction output: worth 0.01999 BTC, it can only be spent by another private key owned by Alice (this is called modification output).
You’ve probably noticed that the transaction outputs didn’t add up to the original 0.8 BTC. The remaining balance of 0.00001 BTC will be paid as a transaction fee to whoever mines the block.
The advantages of wallets
It is difficult to combine the necessary information and perform calculations to successfully create a Bitcoin transaction. There are many steps where human error can cause a user to lose funds. It would also be confusing and difficult to manually track private keys.
We can avoid these problems by using Bitcoin wallets. Wallets help us manage our private keys and make it much easier to send, receive, and store bitcoins. Software wallets, for example, allow us to create and use different private keys for different uses. When we want to send a Bitcoin transaction, the wallet combines the necessary information and performs the required functions to prove that we own the coins we are sending. The same applies when you receive a Bitcoin transaction.
Types of wallets
Depending on your specific needs, there are different types of Bitcoin wallets to choose from. Each wallet comes with a number of trade-offs between security, privacy, and ease of use.
SOFTWARE WALLETS
A software wallet is a program that runs on a computer and provides an interface for the user to send, receive, and store bitcoins. Software wallets are easy to use, but your funds are at risk since they are stored on a computer where hackers can access them.
Exodus is an example of a popular software wallet.
HARDWARE WALLETS
Hardware wallets are physical devices that store and manage private keys for users. They are generally shaped like a memory stick, but some also include touchscreens. These wallets can be expensive and are harder to use than regular software wallets, but private keys never leave hardware wallets. This means that there is a much lower risk of being hacked.
Trezor and Ledger are the two most popular manufacturers of hardware wallets.
PAPER WALLETS
Since private keys are just secret numbers, they can be printed or written on paper for storage and backup (FYI: they are very long numbers!).
Paper wallets are generally not recommended these days, however, as it has proven to be one of the most error-prone methods of storing private keys. Most people, however, print their own seed phrase, which is a way to recover Bitcoin, even if the wallet itself is lost or destroyed.
BRAIN WALLETS
Private keys can be converted into a set of 12 words representing the secret number. These 12 words can be stored as a way to store your private key. Brain wallets are not recommended because if you can’t remember the words, your funds are lost forever.
Not your keys, not your coins
When using the wallets discussed so far, the user is the only one who has access to the private keys. These types of wallets are called non-custodial wallets because no third party has custody of the user’s funds. In contrast, custody wallets are wallets where the user does not directly control the private keys for their funds.
A very common example of a custodial wallet is using an online exchange (such as Coinbase) to store bitcoins, where the exchange has full control over your funds. There are risks associated with using custody wallets, as numerous exchange hacks have shown us in the past.
On the other hand, if you are not very tech-savvy and prefer to trust one of the reliable exchanges to keep your keys private, you may be better off with a custody wallet. The best cryptocurrency exchanges hold most of their cryptocurrencies in something called cold storage, which is basically an offline wallet.
Summary
Bitcoin transactions contain a lot of information and require complicated calculations to send and receive it. Bitcoin wallets do most of the work for you, which reduces the risk of human error and makes the user experience much better.
Users have different needs for wallets but, in general, most users will tend to start moving their cryptocurrencies to offline wallets once they accumulate a considerable amount (as long as they are tech-savvy enough to do so). Of course everyone will have a different risk tolerance for their cryptocurrency and there are some people who trust exchanges 100% and don’t see the need for a wallet. Of course the original intent behind Bitcoin was to create a currency that didn’t require third-party involvement, so that line of thinking is somewhat counterintuitive to the original concept of cryptography.
It’s worth mentioning that this article focuses on Bitcoin, but most cryptocurrencies follow a very similar procedure for using wallets, so this guide would also be applicable to something like Ethereum or Litecoin.
Be sure to carefully consider options and trade-offs when choosing a wallet and remember – not your keys, not your coins!
