How Does A Bitcoin Wallet Work? A Comprehensive Guide

By November 26, 2020May 19th, 2021No Comments

A Bitcoin wallet is a software program designed to store Bitcoin (BTC). Bitcoin, being a cryptocurrency, can’t actually be stored in physical form anywhere. In other words, if a user wants to trade or store Bitcoin, they require a Bitcoin wallet. A Bitcoin wallet allows a wallet holder to send and receive bitcoins, with a private key issued only for them to interact with the wallet address.

How Does a Bitcoin Wallet Work?

Bitcoin wallets don’t physically store Bitcoin like a real-world wallet since virtual currencies, of course, cannot exist in any physical form. Instead, the bitcoins are stored virtually on the blockchain – the blockchain maintains records of each wallet’s total account balance.

What a Bitcoin wallet does store are your public and private keys, so you can trade your Bitcoin, monitor your balance, and perform any other operations. You use a private key to access the funds within your wallet: by entering your private key, you can verify you own the Bitcoin within the wallet linked with said private key, and you can then initiate transfers. The software within a Bitcoin wallet is connected directly to the blockchain, allowing you to submit your transactions to the blockchain ledger.  

A Bitcoin wallet has a ‘wallet address,’ like a bank account number. Just like your bank account number is unique to you, your wallet address would be unique to you too. And just like you can give someone your bank account number for them to transfer funds to your account, you would have to give someone your wallet address to receive bitcoins in your Bitcoin wallet. 

This is how a Bitcoin transaction between two wallets work:

A blockchain stores transactional records of which private and public keys have control over which funds. So when a person wants to send bitcoins to your wallet’s address, first, they have to sanction the transaction with their own private key and pass on the ownership of the funds from their wallet address to yours. Your wallet’s private key must match the wallet address the bitcoins were sent to unlock the funds. When the keys match as per the blockchain’s records, you will receive the bitcoins in your wallet. The trade would now be recorded on the blockchain. 

A cryptocurrency wallet address never reveals the real identity of its holder. Instead, the owner is identified with their digital signature, which is the equivalent of a real-world signature that only you can generate.

Types of Bitcoin Wallets

There are quite a few different types of Bitcoin wallets available out there that vary in terms of accessibility, security, and functionality, among other factors. 

  1. Online/Web Wallets

Online wallets are the most easily accessible wallet option to store your Bitcoin. These wallets are cloud-based and can be accessed from any device with an internet connection. Cryptocurrency exchange platforms like WazirX usually offer web wallets, and these exchange platforms store your private keys on their servers.

Despite the advantages of accessibility and convenience, a very obvious con to the web Bitcoin wallet is that your funds being stored online can mean they are always vulnerable to hacking attempts. However, to eradicate this very problem, many cryptocurrency exchanges store the majority of the funds held in cold (offline) storage – for instance, WazirX stores around 95% of your funds in cold storage! So if you do choose to keep your Bitcoin in an online wallet, make sure your funds are stored on a platform that would provide them with the maximum possible security. 

  1. Mobile Wallets

Mobile wallets appear as apps on your smartphone. They allow you to initiate Bitcoin transactions directly from your mobile. Some also allow you to pay with Bitcoin in real-world marketplaces by scanning QR codes.

Due to mobile phones’ small space, mobile wallets cannot afford to download the entire blockchain ledger like a desktop wallet. So instead, they opt for a much-simplified tech to verify payments – mobile wallets work with small subsets of the blockchain, using nodes within the Bitcoin network to avail the necessary information.

Some prominent example of mobile wallets include:

  • Atomic Wallet: Available for both desktop and mobile devices, Atomic wallet is known for super speedy transactions and instantaneous fund settlements.
  • Jaxx: Jaxx puts a lot of emphasis on security and stores most of the funds under its supervision in cold storage.  
  • Blockchain Wallet: Blockchain Wallet is a non-custodial, open-source wallet and is widely popular for its low fees and user-friendly interface.

Keep in mind, though – mobile wallets aren’t safe from hacking attempts either. Plus, someone can simply access your mobile device to extract your private financial information. 

3. Desktop Wallets

Desktop wallets can be downloaded and installed onto your computer; they store your private key on your computer’s hard drive. Desktop wallets don’t have to rely on any intermediary party for their data, and therefore are safer than online or mobile wallets in theory. However, if there’s a hacking attack on your computer or it gets a virus, you do stand to lose your stored funds.  

There’s a wide selection of desktop wallets available out there that focus on different factors such as security or full anonymity. Some broadly used desktop wallets are:

  • Atomic Wallet: Your private and public keys are encrypted on your computer with the desktop version of Atomic wallet.
  • Electrum: An extensively popular and reliable desktop wallet, Electrum is open source and has a user-friendly, easy-to-understand interface.
  • Bitcoin Core: With Bitcoin Core, you have to download the entire blockchain. It allows you to verify all transactions on your own and gives you full control over your transactions.
  • Armory: Armory, as the name probably suggests, focuses on the safety of your funds; Armory utilizes cold storage options and relies on encryption to thwart any hacking attempts.

4. Hardware Wallets

A hardware wallet stores your private keys within actual physical equipment. So far, there haven’t been any cases of a hardware wallet being hacked into; plus, these devices don’t need to connect to the internet except for transferring funds to another wallet address. Therefore, they are not susceptible to intrusion. Thus, in terms of security, hardware wallets are the safest way to store your Bitcoin.

Some reliable hardware wallets include:

  • Ledger Nano S:  Ledger Nano S comes with high-security standards: the device has a certified secure chip and a custom OS integrated to provide maximum security.
  • Trezor: The best quality of Trezor is that even potential hardware loss won’t mean you’d lose your funds; You can always recover access to your stored Bitcoin through an offline backup with a customized 12 to 24 words long recovery seed.

5. Paper Wallets

Paper wallets can simply mean a paper printed out with your public and private keys. They can also be represented by using software to generate both keys and printing those out. However, this process has been deemed unsafe for several reasons, not least of them being the security issues that arise when you lose the piece of paper with your private and public keys printed on it. 

To conclude, Bitcoin wallets – both online and offline – are only secure to a certain degree. Despite all the security measures taken, the 100% security of digital currency cannot be guaranteed, after all. Once you lose your funds within the decentralized structure of the Bitcoin blockchain, the loss is irreversible. 

Research thoroughly before selecting the type of wallet that suits you the most, and make sure you trust the provider. Pick wallets that already have a good reputation among crypto users and ones that provide extra security layers. For instance, WazirX implements two-factor authentication (2FA) as an additional verification method before letting users access the exchange platform. Armory offers multisig / multi-signature transactions – it requires another user’s permission before a transaction can be made through the wallet. 

Finally, you should closely monitor your Bitcoin wallet once you store your funds in it, so you can do your best to avoid any security threats.

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