This is part 5 in my series of blog posts on cryptocurrency:
Each part builds on the previous ones, so I suggest starting with Part 1.
- Part 1: Why should I care? What’s in it for me? Plus, crypto is about a lot more than just making money
- Part 2: How crypto actually works, why Bitcoin is valuable (even if it’s just “made up!”), and what you should know about blockchains (the tech behind them and how they could influence the future of our world)
- Part 3: How the blockchain keeps running, where new Bitcoins come from (i.e., how mining works), and concerns about Bitcoin’s environmental impact
- Part 4: How crypto offers autonomy, why it can’t be stopped, and the value of decentralization
- Part 5 (this post): How to actually store and use Bitcoin (and other cryptocurrencies), a basic intro to cryptography, and how wallets and keys work
- Part 6: Overview of the different types of wallets, which one is best for you, what to be careful of, and why a hardware wallet might be worth the investment
- Part 7: Ethereum (the #2 most popular cryptocurrency, and the one I’m most excited about), smart contracts, dapps, gas (and the high gas fee problem), Proof of Stake (PoS), and Ethereum 2.0
- Parts 8-10 (in progress): Ethereum use cases and dapps (oracles, NFT’s, DAO’s, etc.), more crypto coins and tokens, other ways of mining and staking, mining pools, crypto indexes, investing, leverage, gurus, risks, DeFi, yield farming, liquidity staking, other opportunities, and how to make money in crypto (a comparison of the risk/reward of some of my favorite options)
Part 5 Reading Time: 16-20 minutes
Ok, you’re on board with Bitcoin. Now, how do you actually store your coins and use them?
That’s where wallets come in (and even if you’re already familiar with crypto, wallets probably aren’t exactly what you think they are).
It’s easy to get confused here, so I’ll explain wallets in progressively deeper layers, starting with a metaphor and then fleshing out from there.
Layer 1: Money in your pocket
Think of a cryptocurrency wallet as a digital version of the physical wallet you keep in your pocket.
A wallet is a piece of software you run on your computer or an app that you run on your phone. It’s where you store all your cryptocurrency.
There are many different wallet apps to choose from with different features, but some of the most common ones are MetaMask, MEW, Ledger Nano, and Coinbase (Coinbase is both an on-ramp/exchange as well as a wallet).
You can use your wallet app to see how much of each coin you have, and you can also send coins to other people’s wallets and receive coins from them. Plus, some wallets have additional features like the ability to trade one type of coin for another.
“Wait, so my cryptocurrency is stored on my computer or phone? If I lose my phone, I lose my money?”
Layer 2: Money in the cloud
A cryptocurrency wallet is like a traditional wallet in one sense: You use it when you’re spending or receiving money. But beyond that, it’s actually quite a bit different.
Your wallet is less like a box full of cash and more like the address of your bank.
Here’s the key part that might be a bit difficult to wrap your head around: Your cryptocurrency isn’t actually stored in your wallet.
Where is the cryptocurrency actually stored, then?
In the blockchain.
Remember that the blockchain is a massive ledger containing every single cryptocurrency transaction that’s ever happened between anyone in the world.
That’s right: No one actually has cryptocurrency on their computer. All cryptocurrency lives as transaction records on the public ledger of the blockchain.
For example, imagine that the very beginning of the Bitcoin blockchain ledger looked like this:
- Everyone starts with 0 BTC (Bitcoin)
- Jamal converts $500 USD (US dollars) to 5 BTC
- Jamal pays Alice 2 BTC
Now, say Jamal and Alice both open up their wallet apps on their phones:
- When Jamal’s wallet checks the blockchain ledger, it knows that he has 3 BTC (since he started with 5 and gave 2 to Alice).
- When Alice’s wallet checks the blockchain ledger, it knows that she has 2 BTC (since she started with 0 and received 2 from Jamal).
Since we can look all the way back to the very beginning of each blockchain, we can calculate exactly how much money everyone should have right now based on all the transactions that have happened along the way.
In other words, it’s less like Bitcoin is cash in your pocket and more like everyone has a copy of a massive spreadsheet that calculates how much money everyone has at any given time. Rather than asking how much money someone has, you can simply look it up on the spreadsheet.
You can’t just search for someone’s name, but you can look up how much money a certain wallet has. And, there are various techniques you can use to figure out who owns certain wallets. For example, if someone announces on Twitter that they just bought a famous piece of art for 17 BTC, you can simply open up the Bitcoin blockchain and look for a recent transaction for that amount; then, you can trace it back to a certain wallet and look up other transactions made from that address.
Don’t worry if all this sounds complicated—most wallet apps are simple to use, and you can see how much cryptocurrency you have just as easily as you check your account balance in your regular bank app.
“Wait, if everything is on the public blockchain, what’s to stop anyone from claiming other people’s money?”
Layer 3: Money through cryptography
The real truth is that—in its simplest form—a wallet is just a couple of addresses made up of a long string of numbers and letters. You could theoretically just memorize them, but wallet software makes all this a whole lot easier.
Here, I need to explain just a little of how cryptography works (remember that cryptography is the practice of using codes so that you can securely communicate with someone without third parties listening in—this goes way back to before World War 2 and even to ancient Greece).
Why cryptography? Well, the basic challenge we need to solve here is this:
The blockchain has a record of all transactions (Jamal received 5 Bitcoin, Jamal sent 2 Bitcoin to Alice, etc.).
But how can Jamal prove that he’s the same Jamal from that transaction? And how can Alice prove that she’s the right Alice? What if someone else named Alice comes along and claims that the money from Jamal was meant to be sent to her?
We need two things:
- Jamal needs a way of “signing” the transaction to say that, yes, he is intentionally sending money to Alice.
- Alice needs a way of giving Jamal a specific address to send the money to so the blockchain network can ensure it goes to the right person.
A wallet app uses cryptography to solve both those problems.
It’s fascinating stuff that quickly gets super complex, but here’s the basic way it works:
- When you create a new crypto wallet, it generates a “private key” for you. Think of this as the password to your bank account. If you share it with anyone, they can open your crypto wallet and send all your money to their wallet.
- The private key is a long series of letters and numbers. But, to make things easier, it’s often represented by a seed phrase.
- A seed phrase is a series of 24 regular dictionary words (e.g., “corn action ribbon…”). But when you plug those words into the cryptographic algorithm, it turns them into your private key (a long string of letters and numbers). You can think of the seed phrase as the private key converted into a form that’s easier for a human to keep track of.
- Your wallet also generates a “public key.” Think of this as your home address that you can give other people to send you money.
- Here’s the amazing part: Through some fancy cryptographic tricks, you can use a combination of your private key and the recipient’s public key to send them money in an extremely secure way (this is probably still confusing, so I’ll explain it again in the next section in a different way). Here’s what happens:
- Your private key is what you use to sign the transaction to confirm that the real you is intentionally taking this action (don’t worry: your wallet handles that for you—you never have to actually sign anything).
- But, your private key isn’t simply stamped on the transaction for anyone to see—then they could just copy it. Instead, your private key is run through a special algorithm to generate a hash. Think of this as a one-way conversion: Your hash is a string of letters and numbers that can only be created by someone who has your private key; but, you can’t run it the other way. You can’t use someone’s hash to figure out their private key.
- So, someone else’s wallet can now confirm that the hash was indeed generated by your legitimate private key, but it can never actually see your private key. Amazing, huh? (And yeah, I know this sounds unbelievable, but this stuff is invented by people with PhD’s in mathematics and computer science.)
If you’re curious, here’s basically what an entry in the blockchain ledger actually looks like:
“bc1qeyce9za36r6ectyuj04stug6gy2gdu70229udt sent 2.0 BTC to 34oyn5hBrNtedyvR4s9crWwt6vQnehhCEA on 2021-05-04 at 19:01″
That first string of numbers and letters would be a hashed version of Jamal’s public key (signed with his private key, which is hidden), and the second string would be a hashed version of Alice’s public key.
In fact, you can literally see all the Bitcoin transactions ever right here.
Let’s recap how wallets and keys work:
- Imagine that everyone with a Bitcoin wallet is given a secured physical vault. The vault has two different locked doors.
- The first locked door on the top of your vault opens to a piggy bank slot where coins can be deposited; but, it’s too small to reach in and pull coins back out. You want anyone to be able to deposit coins into your vault, so you make a million copies of the key to that slot and hand them out to all the other Bitcoin users. That key is your public key.
- The second locked door is the big vault door on the front. When you open this door, you can take out all your coins. So, it’s important to keep this key safe. It’s called your private key.
- Both the public key and the private key are really just long strings of numbers and letters that are extremely hard to crack.
- When a public key is publicly shared, it’s hashed by your wallet so that other computers can recognize it (and they know for sure it was signed by your private key), but your actual keys aren’t shared.
- Since it’s so important to never lose your private key, your wallet also gives you a seed phrase of 24 words that can recreate your private key if you lose it (which is why you should never share your seed phrase with anyone else).
One more thing to emphasize: Notice that all of this is happening without a bank or traditional financial institution being involved. You’re able to store money in a digital wallet and send it to other digital wallets without any middle-man. Everything is highly secure, but you’re not paying a team of security experts and administrators to manage the infrastructure as with a traditional bank.
You don’t pay the blockchain to store your money for you. The only time you pay a small fee is when you initiate a transaction like buying or selling—and that fee goes directly to whichever person lent their computer resources (i.e., their node) to validate your transaction.
Cool. Now how do I actually get a wallet? What do they look like? Which one is best? Find out in Part 6: Overview of the different types of wallets, which one is best for you, what to be careful of, and why a hardware wallet might be worth the investment.