Explore the different kinds of wallets to understand how each one works and what benefits or weaknesses they have, so you can make the appropriate choice for your digital assets.
What are Digital Wallets?
Digital wallets are digital versions of physical traditional wallets and by using blockchain technology, it allows us to securely store, access and operate several digital assets such as personal documentation and cryptocurrencies, among others. Digital wallets are linked to a “subject”, which can be an individual, an organization or even a thing. They function as software applications, and optionally an associated hardware module, to securely store and access the information they handle.
There are different types of digital wallets depending on the use and according to different technical characteristics.
Three important concepts you should know about.
Before moving forward, and for a better understanding, it is important to briefly introduce some interconnected concepts that are an important part of all digital wallets.
- Private keys: Private keys are the access passwords of a Blockchain account.That is to say, it is the key that opens the safe and, whoever has it, will also have ownership and control over its contents (ex: Cryptocurrencies, Credentials, NFT etc).
- Public Keys: Public keys are the identifications of a Blockchain account. They work like a bank account number. They are used to ensure that you are the owner of an address. It is public in that you can distribute it freely since no one will be able to access your information since the corresponding private key is necessary to access it. The public key arises from an encryption process of the private key.
- Digital Signatures: With digital signatures you can prove that you are the owner of a private key but without revealing it, since they are the result of the encryption of a certain transaction and the private key that generates a unique public key.
What different types of digital wallets can we find?
Both types of wallets can manage private keys and digital signatures, but they differ mainly in the specific use of each one. Crypto wallets are developed to operate with assets stored in blockchain networks, which means that the transactions are carried out on the network and are public to everyone. Identity wallets perform private transactions where access to this information is just for parties involved.
Crypto Wallets: They focus on managing digital assets that the subject owns (Crypto Values, NFT). In crypto wallets, private keys are used to demonstrate control over digital assets that are stored in a blockchain network, this means that these wallets only store private keys, public keys and blockchain addresses since the rest of the information is stored in blockchain networks.
In this way, they are oriented towards preparing and signing transactions that will be processed by a blockchain network. These transactions are public and therefore known to all those who have access to a network node.
Crypto wallets do not implement a communications scheme between the parties involved in each transaction since the transactions are carried out with the intermediation of the blockchain network used in each case.
To exemplify, in the case of a transaction with cryptocurrencies:
User A can give user B the address of their wallet, which arises from the public key of his account. When user B makes the operation, that transaction is processed in the blockchain network and user A receives the amount of cryptocurrency sent in their wallet. What the user sees in their wallet is confirmation that the transaction was successful on the network and that they are the owner of those cryptocurrencies. That transaction is now public to anyone with access to a node on the network.
Identity Wallets: They are used to store, manage and operate with verifiable credentials that describe some characteristic of the identity of the subject. (ID, University degree, medical history). They are responsible for the private and secure storage of all information associated with the identity of the subject, mainly their verifiable credentials. Which means that the digital assets are inside the wallet and not in the blockchain network.
In this type of wallet, the private keys are used to demonstrate control over the digital assets that are stored in the wallet.
Identity wallets are aimed at preparing and signing credentials or proofs that will be exchanged peer-to-peer between the actors involved. These operations are totally private and only known by the parties involved. As it does not have intermediation of any kind, it requires the implementation of communication protocols of the peer-to-peer type.
A practical example of the use of identity wallets can be the case in which a person needs, to access an establishment, to prove it is over 18 years of age. By having a verifiable ID card in your wallet, you can, for example, use a QR code to prove to the establishment that you are over 18 years of age. In this case, that code would only show that you meet the requirement, but it does not show your age or date of birth. The transaction is peer-to-peer and is not stored on any network. It is private between the actors.
These types of wallets emerge as a fundamental part in the implementation of the self-sovereign identity. We recommend reading our articles on this topic.
Custodial Wallets and Non-Custodial Wallets
This group of Wallets are divided by an important characteristic: Who has control over the private keys?
Custodial wallets: The main characteristic of this type of wallet is that the control of the private key is held and managed by the wallet itself, that is, a third party. The user will have the key to access his wallet but will never have the private key. A clear disadvantage is that in the event that the wallet closes, the user loses the contents of his wallet. “Not your keys, not your coins”. The main advantage of this type of wallet is that they are easy to handle.
Some examples of Custodial wallets are Binance and Coinbase.
Non-Custodial Wallets: Non-Custodial Wallets are platforms that allow users to possess and store their private keys, giving them full control and making them 100% responsible for the security of the keys. There is a recovery phrase that appears when creating the wallet user and it is through this phrase that we can recover the assets of the wallet in case of losing it. It is important to protect this phrase written on paper in one or more safe places.
This type of wallet has no control or power over the information in it and that is its main advantage. If the wallet were to disappear, the user can download another compatible one and enter with their recovery phrase. The disadvantage of this type of wallet is that they are not as simple to manage and it implies more security responsibility for the user. Some examples of non-custodial wallets are Metamask and Trust wallet.
Hot Wallets and Cold Wallets
These types of wallets are different from each other according to where assets are stored.
Hot Wallets: These wallets need to be connected to the Internet for them to be used. There are web versions, mobile apps and desktop apps. Although they are easily accessible to operate, the biggest problem we face with this type of wallet is the possibility of being vulnerable to information hacking. Users who have large amounts of digital assets do not usually use this type of wallet to store them, but instead keep in them a moderate amount to trade in the markets and keep most of the assets in Cold Wallets.
Examples of these wallets are Trust Wallet, Coinbase, Coinomi.
Cold Wallets: This type of wallet does not need an internet connection. They are external devices like USB. It is a safer way to store your digital assets. They only connect when performing operations but even when connected it is difficult to access the assets since the signing of the transactions is done on the device.
The best known cold wallets are Ledger, Trezor, Coolwallet,
How to choose the best digital wallet for you?
The answer to this question is not definitive as it depends on several factors. Of course, depending on the final use that we are going to give the wallet, we are going to choose between a Crypto wallet or an identity wallet. Although it is very possible that in the near future we will find available wallets that fulfill both functions. But once this is defined, what kind of wallet should we look for? The first thing we should think about is whether or not we want to be the owners of the private key or if we prefer not to handle this great responsibility and delegate it to a third party. It seems like an easy decision, but it is not, since we must bear in mind that if we choose a non-custodial wallet and lose the recovery phrase, we will lose all the digital assets we have.
Other aspects to take into account
On the other hand, a custodial wallet that has a good reputation in the market can relieve us of this responsibility and make the user experience simpler. There are very reliable custodial wallets, but you have to know that as a user you will never have their private key.
Another important point is to define if we are going to opt for a cold or hot wallet. We want our digital assets to be connected to the internet or we prefer them to be offline until we have to perform a transaction. In this case, one option would be to opt for a combination of both. On one hand, having a hot wallet with the assets we need to operate and carry out transactions, but also having a cold wallet where we can store most of the assets with which we are not operating.
