For someone to store and transact bitcoin, they must own a bitcoin wallet.
Although the analogy of a wallet may seem like a good fit for a digital currency, the reality is that a normal, physical cash wallet is quite different from a bitcoin wallet.
These two objects protect different types of property. In fact, some would argue that a bitcoin wallet holds no money in it whatsoever.
The object that a Bitcoin user needs to secure is not their bitcoin, but the private keys that unlock their bitcoin on the blockchain.
With a bitcoin wallet, no bitcoin is stored on the local computer or in a bank somewhere. All bitcoin exists on the decentralized ledger, known as the Bitcoin blockchain.
It may be more correct to refer to a bitcoin wallet as a bitcoin keychain.
It stores all of the private keys associated with your bitcoin addresses. Instead of worrying about securely storing their bitcoin, users should be concerned with safely storing their private keys. Copies of these keys can also be made, which means the keys can be backed up and stored in multiple locations, much like real, physical keys.
There are a few different types of bitcoin wallets used today, and each of them come with their own tradeoffs between security and convenience:
A software wallet is an application that you may download on your desktop, laptop, or smartphone to store your private keys locally.
Software wallets are good for storing small amounts of bitcoins, but not large amounts.
Examples of this type of wallet include Mycelium, Bitcoin Core, Bitcoin XT, Electrum, Armory, and BRD.
A hardware wallet is a physical hardware device that is built with the sole purpose of securing Bitcoin private keys. The device keeps private keys away from an Internet-connected device and allows users to sign transactions in an offline environment.
Hardware wallets are good for storing medium to large amounts of Bitcoin.
Examples of bitcoin hardware wallets include Trezor, Bitbox, Keepkey and Ledger.
A paper wallet has always been a popular option for secure storage of bitcoin private keys. With this method of storage, private keys are written down or printed on a piece of paper rather than stored on a computer.
Usually a computer not connected to the internet is used to generate a paper wallet. Computer connected to the internet are more liable to be hacked.
This type of wallet has become less popular since the development of hardware wallets.
A web wallet is a wallet where the private keys are stored in the cloud rather than a local computer. This allows a user to easily have access to their bitcoin on multiple devices.
Private keys are generated locally and then encrypted, which means the wallet application provider does not have access to user funds.
Web wallets are often hacked and are not recommended for storing bitcoins, unless it’s a very small amount.
An example of this type of wallet is Blockchain.info.
A custodial wallet is a special type of web wallet that uses multi-signature addresses for added security.
In most setups, a 2-of-3 multi-signature address is created between a user and the wallet provider. One key is held by the user, one key is held by the wallet provider, and a third key is held offline (either by the user or a third party).
A signature from the user and the custodian is needed on every transaction, and the custodian is able to check for suspicious activity before adding their signature to a transaction – in a manner similar to a bank or payment processor. The difference is that the custodian never has full control over a user’s funds. The user can always use their own key and the backup key to move their funds to a new wallet.
An example of this type of wallet is BitGo.
One last thing to keep in mind when it comes to bitcoin wallets is that there is a difference between a wallet and a bank.
Some Bitcoin users view Coinbase and Gemini as bitcoin wallets, but these Bitcoin companies operate much more like banks.
The private keys are what users need to protect when it comes to using the Bitcoin network. When you hand someone else control over your private keys, you are essentially making a deposit at that financial institution – much like a deposit at a bank.
This is not to say that bitcoin banks are inherently bad.
Coinbase and Circle have done wonders for bringing more users into the ecosystem.
It is simply important to remember that whoever controls the private keys controls the bitcoin attached to those keys. A misunderstanding of this point has led to hundreds of millions of US dollars being lost in the past, so it’s important to understand this key difference in how Bitcoin private keys can be stored.
Understanding how bitcoin wallets work is an important aspect of safely using this new technology in its early years of development.
Wallets will become much more user friendly over time, and some devices may eventually come with preinstalled wallets that interact with the blockchain without the user’s knowledge in the near future. For now, it’s vital to keep in mind that the private keys are what you need to protect if you want to keep your bitcoin safe from hackers, user error, and other possible issues.