Understanding how cryptocurrency wallet works, custodial & non-custodial explained

2022-11-02, 07:58

TL: DR
- Crypto wallets are software that keeps public and private keys and connects to various blockchains, allowing users to monitor their balance, send money, and perform other operations.
- A wallet address is comparable to a bank account number. There is no harm in giving someone else your bank account number and also your wallet address because they will need it to transfer your funds.
- A wallet chooses a random address from a blockchain's valid range by creating a new public/private key pair and performing complex calculations to cloak the public key and format it according to the Blockchain rules.
- A Custodial Wallet is one in which the third party or admin holds the Wallet's private keys, while in a Non-Custodial Wallet, the private keys are kept under the user's control.

Keywords: cryptocurrency, Wallet, Blockchain, public key, private key, wallet address, custodial Wallet, non-custodial Wallet.

Introduction

Cryptocurrency wallets are like repositories that store users' public and private keys and provide an easy-to-use interface for managing crypto balances. They also facilitate cryptocurrency transfers via the Blockchain. Users can interact with decentralized applications (dapps) through some wallets or buy and sell crypto assets.

It is critical to remember that cryptocurrency transactions do not represent the sending of crypto tokens from your mobile phone to another person's mobile phone. When you send tokens, you authorize the transaction with your private key and broadcast it to the blockchain network. The network will then include your transaction to reflect the updated balance in the two addresses (yours and the recipient's).

What are Crypto Wallets?

Cryptocurrency wallets are software that holds public and private keys and connect to various blockchains, allowing users to monitor their balance, send money, and perform other operations. Cryptocurrency wallets read the general ledger to show you the credits in your addresses and the private keys that enable you to make transactions. When someone sends you a cryptocurrency, they sign off ownership of the coins to the address associated with your Wallet. To access those coins and unlock the funds, the private key in your Wallet must match the public address assigned to the currency. If the public and private keys are the same, the balance in your digital Wallet will rise while the senders' will fall.

Components of Crypto wallets: Public and Private Keys

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A key as a component of crypto wallets refers to a long string of random, unpredictable characters. Whereas a public key is similar to your bank account number and can be widely shared, a private key is identical to the password or PIN and should be kept private. Every public key is paired with one corresponding private key. The two work together to encrypt and decrypt data.

How Cryptocurrency Wallets Work

A wallet chooses a random address from a blockchain's valid range by creating a new public/private key pair and performing complex calculations to cloak the public key and format it according to the Blockchain rules. The content of valid addresses on a blockchain is so extensive that it is more plausible that the Earth will be destroyed in the next five minutes than that two wallets randomly select the same address. The address generated by the Wallet is the address the sender uses to transfer cryptocurrency and is publicly recorded on the Blockchain. The private key is required to unlock the cryptocurrency at that address.
It is common practice to use a different address for each cryptocurrency transaction to ensure maximum privacy.

A wallet stores the address and key for the cryptocurrency assets through a transaction. It also performs the necessary calculations to receive cryptocurrency. Each new address and key in a non-deterministic wallet is generated at random. The Wallet is unable to recreate a previously used key. Backing up the Wallet is critical because a lost wallet equals lost cryptocurrency. The private key in a deterministic wallet is generated using the Wallet's seed phrase or password. Each subsequent transaction key is generated using the private key. If the Wallet is damaged or destroyed and no backup is available, a deterministic wallet can recreate the previous keys using the seed phrase or password.

Types of Crypto Wallets

There are numerous free and paid wallets available. The majority of cryptocurrency exchange websites offer a free software wallet. There are different crypto wallets, but this article will focus on custodial and non-custodial types of crypto wallets.

What exactly is a Custodial Wallet?

A custodial Wallet is a type whereby a third party or admin holds the Wallet's private keys. In this type of Wallet, this third party assumes the role of "custodian," in charge of preserving the property of crypto owners.

The majority of custodial wallets are cryptocurrency exchange accounts. For example, a new cryptocurrency investor may decide to open an account with a significant cryptocurrency exchange such as gate.io. Suppose they buy cryptocurrency but decide to keep it in the exchange account. In that case, gate.io holds its cryptocurrency in a custodial wallet and is now responsible for managing the wallet keys.

What exactly is a Non-Custodial Wallet?

It is a crypto wallet in which the crypto owner is directly responsible for key management. This responsibility implies that if the owner loses or misplaces the keys, the cryptocurrency in the Wallet may be lost forever. These can take the form of web browser-based software, regular downloadable software, hardware, or paper. Hardware wallets are the most secure method of storing cryptocurrency wallet keys.

Pros of Custodial Wallets
One of the most notable advantages of a Custodial wallet is that, unlike other wallets, it does not charge a transaction fee. It enables customers to conduct free transactions within the ecosphere. Freewallet is an excellent example of a Custodial wallet that saved users around $500,000 in network fees in 2019.

Also, your custodial Wallet is kept by a third party or exchange. As a result, even if you misplace your private key or forget the reminiscence phrase, It is simple to regain access to your Wallet and accumulated funds. Another advantage of custodial wallets is that the centralized authority in charge of your Wallet demonstrates backup capabilities. This backup makes it easier to reverse any transaction or restore a previous version.

Cons of Custodial Wallets
Custodial wallets also involve some elements of risks. Crypto holders risk losing their assets if the custodian's security or solvency is jeopardized. A case that vividly comes to mind is the abrupt demise of the cryptocurrency lending service Celsius Network. In June, the platform, which had previously managed tens of billions of dollars in investor funds, abruptly ceased depositor withdrawals. Several other struggling crypto lending platforms quickly followed suit, leaving crypto investors out billions of dollars.

Some have also argued that custodial wallets result in centralization, which contradicts the crypto ethos of decentralization. Holders of custodial wallet-stored crypto may conflict with the custodian or the government agencies that regulate the custodian. In such instances, their crypto assets are at risk of seizure.

Pros of Non-Custodial Wallets
The primary reason that Non-Custodial accounts are gaining popularity is that they provide users with individual access to their funds. Unlike Custodial wallets, these wallets do not require third-party validation for every transaction, simplifying the entire procedure and making instant withdrawals more convenient. Because you are responsible for all aspects of your online Crypto wallet and its funds, the risk of a data breach is much lower. This fact is one of the main reasons why 66.5% of cryptocurrency holders now use non-custodial and mobile storage solutions.

Cons of Non-Custodial Wallets
Assuming responsibility for managing one's keys is a big step for any cryptocurrency investor. Still, those with little experience with crypto technology risk losing access to their funds if they fail to take necessary precautions. Non-custodial wallet users are also more vulnerable to phishing, scams, and crypto hacks than those using custodial wallets.

Conclusion

Your Wallet safeguards your cryptocurrency, but you must protect your Wallet as well. In addition to the password or passphrase, many wallets offer two-factor authentication, which requires both something you know (a password or pin) and something you have (a fingerprint or cell phone). If this option is available, enable it.
It would be best if you also backed up your Wallet regularly in case something happens to it or the data contained within it. Avoid sharing your password or passphrase with anyone, but make it available to someone you trust in the event of your untimely death. Take standard online security precautions to avoid phishing and malware that steal cryptocurrency addresses and private keys. Understanding how a wallet works and its stores' information should allow you to secure it better and your cryptocurrency assets.

Author - M. Olatunji, Gate.io Researcher
Disclaimer:
* This article represents only the views of the observers and does not constitute any investment suggestions.
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