A beginner's guide to on-ramping into cryptocurrency
Do I need a crypto wallet?
In short, yes. If you want to buy and use Bitcoin or any other cryptocurrency, you will need a digital wallet.
What is a cryptocurrency wallet?
A cryptocurrency wallet is a mechanism by which you store your private and public keys. If you want to transact in either Bitcoin or any other cryptocurrency, you will need to have a digital wallet. Cryptocurrency wallets are usually software programs that interface with various blockchains so users can see their balance, send and receive currency. There are other forms of offline wallets, which are described below. However, the key point to understand is that a cryptocurrency wallet is a place to hold your private and public keys. Bitcoin, and all other cryptocurrencies that have since followed, are built upon public-key cryptography.
What is public key cryptography?
Public key cryptography, or asymmetric cryptography, is a cryptographic system that uses pairs of keys: private and public. These keys are generated by cryptographic algorithms based on mathematical problems to produce one-way functions. To maintain effective security, only the private key is required to be kept private. The public key can be openly shared without compromising security in any way. A public and private key pairing comprises of two uniquely related cryptographic keys (long random numbers).
What is a private key?
A private key is a small piece of code generated via an asymmetric-key encryption process. When paired with a public key, it is used to set off algorithms for text encryption and decryption to transform a message to a readable format. This is a crucial feature to understand in the world of crypto. Your private key is a sophisticated form of cryptography that allows you to access your cryptocurrency. A private key is an integral aspect of Bitcoin and altcoins, as its security feature helps to protect a user from theft and unauthorised access to funds. A private key must remain confidential, known only to its owner.
What is a public key?
The public key is able to be distributed openly and made available to other people. It is the address to which your cryptocurrency can be sent. As a result of the key pair being mathematically related, anything that is encrypted with a public key can be decrypted only by its corresponding private key, and vice versa. It is computationally impossible to derive a private key based on the public key. This is why public keys can be shared freely, allowing users an easy and convenient means to encrypt content and verify digital signatures. As private keys must be kept secret, only the owner can decrypt the content and create a digital signature.
How does a crypto wallet work?
The first thing to understand is that digital wallets do not store your currency but are in fact holding records of transactions stored on the blockchain. The blockchain is the master record. When someone sends cryptocurrency to your wallet, they are transferring ownership of the coins to your wallet’s address. In order for you to take ownership of the currency and to transact, the funds must be unlocked. To do this, the private key stored in your wallet must match the public key the currency has been sent to. If the public and private keys match, the balance will be credited to your digital wallet and debited from the sender’s wallet. Each transaction is recorded on the blockchain of the coin or token that you have transacted in (e.g. Bitcoin or Ethereum).
To create a cryptocurrency address, a private key must first be generated. It is the private key that grants a user ownership of the cryptocurrency on an address. Subsequently, a corresponding public key can be derived. A digital wallet provides this functionality. Digital cryptocurrency wallets automatically generate and store private keys for you. When you send crypto from one of these blockchain wallets, the software signs the transaction with your private key without disclosing it. This in turn informs the network that you have the authority to transfer the funds on the address that you are sending from.
How safe is public key cryptography?
Public key cryptography uses asymmetric-key encryption. This involves the use of two different keys at once – the combination of a private key and a public key. As explained above, the private key is known only to your wallet, while the public key is provided by you to any other computer (e.g. wallet) that wants to communicate securely with it. The key pair is based on prime numbers (numbers divisible only by itself and one, and large ones at that) and are long combinations, making the system extremely secure. As there is an infinite number of prime numbers available, there are essentially infinite possibilities for keys.
The security of public key cryptography is derived from the one-way system. The sending computer encrypts the secret data using the receiving computer's public key and a mathematical operation. The power of public key encryption is in that mathematical operation. It's a one-way system, which means it is unfeasibly difficult for a computer to reverse the operation and discover the original data. Even the public key cannot be used to decrypt the data.
What are the different types of cryptocurrency wallets?
There are various types of wallets supporting the storage of cryptocurrency, which we can summarise in three distinct categories: software, hardware and paper.
What is a software wallet?
Software wallets cover those on a desktop, online or on mobile.
Desktop wallets are downloaded and installed on a single computer - only accessible from the computer on which they are installed. A desktop wallet is seen as having an extremely high level of security, however if your computer is hacked, succumbs to a virus or you throw it out into the trash, there is a high likelihood you will lose all your funds. We’ve all read about the guys who lost millions in mined Bitcoin from the early days, lost on old hard drives that they threw away.
Online wallets sit in the cloud and are accessible from any device, anywhere you have a connection. Online wallets store your private keys securely online and are controlled by a third party, i.e. the provider of the service to you. When you open a cryptocurrency exchange account, you will automatically have a wallet. This is known as an exchange-hosted wallet. This is an extremely convenient way to on-ramp, but in this instance you do not have control of the private and public keys - it’s all integrated in the account solution with the exchange. For many, this is a convenient solution but for others who prefer the idea of owning and maintaining total control over the funds associated with their corresponding public keys, it doesn’t suit their preferences. Online wallets have been vulnerable to hacking attacks and theft in the past (think Mt. Gox, Bittrex, Bithumb) but most of the major exchanges, who offer online wallets, have since enhanced their security significantly and hold the majority of their funds in cold storage.
Mobile wallets are smartphone apps and provide convenient access. They can be used anywhere, including retail stores which offer payment in crypto.
What is a hardware wallet?
Hardware wallets are available for multiple cryptocurrencies and function to store private keys on a hardware device, such as a USB. Hardware wallets are held offline, which means they are extremely secure, but do support online transactions. Using a hardware wallet requires you to plug the device into an online computer, enter your security details and send currency. Hardware wallets have major advantages over standard software wallets in that private keys are often stored in a protected area of a micro-controller and cannot be transferred out of the device in plaintext. They are also immune to computer viruses that steal from software wallets. Furthermore, hardware wallets can be used securely and interactively; private keys never need to touch potentially vulnerable software.
What is a paper wallet?
The term ‘paper wallet’ can be used to describe a paper copy of your public and private keys or a software programme that securely generates a pair of keys, which are then printed to paper. A paper wallet is a simple and secure solution to holding your crypto, but not necessarily the most user-friendly for everyday use. Transferring crypto to a paper wallet is simple, involving the transfer of funds to the public address. To withdraw crypto from a paper wallet, a user will need to transfer funds from the paper wallet to a software wallet. This can either be executed manually by entering the necessary private keys or by scanning the QR code on the paper wallet.
How safe are crypto wallets?
Security of your wallet depends on the type of wallet you are using and how paranoid you are! In the case of online wallets – it also depends on the service provider. An offline desktop wallet offers safety in the fact that it cannot be hacked because it is not connected online and is not reliant upon a third party for security. However, you as the owner are responsible for the physical safety and security of your machine and data. If your disk gets fried, so does your crypto!
Online wallet security has improved significantly in recent years as the big crypto providers have improved and strengthened their products and services. Online wallets with providers like Coinbase, Binance and Kraken offer market leading security and peace of mind. Another advantage is that you don’t have the headache of needing to store and protect your private keys – it’s all integrated and automated in the online digital wallet.
Hardware and paper wallets are held offline, which means they are extremely secure. However, these are physical items and the owner is responsible for their safekeeping.
What is a multi-cryptocurrency wallet?
A multi-cryptocurrency wallet is one that supports the ability to hold multiple coins and tokens. Rather than a wallet that only supports Bitcoin, it makes sense to set up a multi-currency digital wallet. This will allow you to buy, hold or trade in a range of other cryptocurrencies from a single wallet. Most major exchange-hosted wallets offer multi-currency and are extremely easy to use, providing deposit addresses for each of the supported currencies on the exchange.
How do I protect my crypto wallet?
First and foremost, you need to establish strong discipline regarding your general online security. It’s good practice for your digital life in general, but especially important if you are entering the world of investing in cryptocurrency. The following measures should always be followed:
- Use a secure internet connection at all times
- Maintain strong antivirus software on your devices and keep it up to date
- Use strong and unique passwords for your online wallets
- Use two-factor authentication (2FA) for all online wallets
- Set up additional passwords where possible, such as extra trading and withdrawal security
- Ensure you are using the maximum security measures on your Google and Microsoft profiles, including 2FA
The next thing to consider is ensuring you only store small amounts of cryptocurrency online for everyday use. For obvious reasons, you should hold the vast majority of your funds in a high-security environment. If you are using an exchange-hosted wallet, it is prudent to move the majority of your holdings out of your trading account and into a vault, which adds additional controls and layers of security. This also ensures your crypto is being held in cold storage. If you are using a desktop or offline wallet, back it up to protect yourself against computer failures.