A guide to understand different types of crypto wallets

Wallets are an integral part of the crypto ecosystem, finding applications in areas such as storing key pairs safely and making sure you’re able to send and receive crypto tokens. Unlike traditional wallets, crypto wallets do not hold any cryptocurrency or asset. They simply help store your public and private keys that allow you to sign on transactions and display your asset balances by reading a public ledger.

Back in the day when crypto was still in its nascent stages, users had to memorize and manually enter their private keys to perform transactions. But with the advent of crypto wallets, the need to manage long private keys has gone away. Users could moreover start interacting with decentralized applications (dApps) through crypto wallets.

Read on as we walk you through how crypto wallets work, why you need them, and the different types.

How Do Crypto Wallets Work?

Crypto wallets are nothing but software applications or hardware devices that help you store your key pairs and interact with blockchains. Since any cryptocurrency you hold exists on a blockchain, what your wallet does is keep track of the addresses and key pairs to access or sell your crypto assets. Say you want to send someone crypto. All you have to do is enter the wallet address of the recipient, sign using your private key, and pay the transaction charges. What’s more, crypto wallets also have a backup mechanism for safeguarding your private keys in the form of seed phrases– in the case that you forget your private keys, you can simply use the seed phrase to retrieve them from your crypto wallet.

Why are Crypto Wallets Important?

Crypto wallets are important because they ensure that you can access your crypto assets when needed, and also sign on transactions to send crypto or interact with dApps. In essence, crypto wallets give you a secure and private means to access crypto and web3 apps. But not all crypto wallets are the same. With different types of wallets currently available– hot and cold– custodial, self-custodial, or non-custodial– it is important to learn the differences between them for making an informed decision.

Types of Crypto Wallets

Crypto wallets can be broadly classified into two categories based on whether they’re a software application or a hardware device– hot and cold wallets, respectively. Some easy examples of hot wallets include web-based wallets, desktop wallets, and mobile wallets. Cold wallets, on the other hand, come in the form of paper wallets or hardware wallets.

In hot wallets, such as web wallets or mobile wallets, private keys of users are encrypted and then stored in an app which is connected to the internet. While hot wallets are known to be vulnerable for security reasons as they’re connected to the internet, we now have better encryption and privacy mechanisms in place to safeguard user data and keys.

Cold wallets, as a result of being completely offline, are deemed highly secure. That being said, they aren’t as easily accessible and comfortable to use, when compared to hot wallets. Cold wallets are further categorized into paper and hardware wallets. A paper wallet is nothing more than the private and public keys written down or printed out. Hardware wallets, on the other hand, are USB or Bluetooth devices. When it comes to choosing between hot and cold wallets, the one deciding factor is how often you need to access your wallet. If you’re someone who trades frequently, cold wallets become an impractical choice, and you’re better off with hot wallets.

Now that hot and cold wallets are out of the way, let us dive deeper into another important factor to classify wallets– the mechanism through which private keys are stored. Depending on how a user’s private keys are stored, crypto wallets are classified into custodial, self-custodial, and non-custodial.

Custodial Wallets

In a custodial wallet, users’ private keys are handled by a trusted third-party. Each time a user has to transact or interact with a dApp, the third-party platform will facilitate the process by signing the transaction using private keys on behalf of the user. Instead of memorizing private keys and seed phrases, users simply login with a username and password to access their custodial wallets. Privacy-conscious users tend to raise concerns about having to trust a third-party for managing private keys. That is when self-custodial wallets become a viable alternative.

Self-Custodial Wallets

Self-custodial wallets give full control of private keys to users, and are assigned a mnemonic phrase for recovery purposes. Each time a user transacts using a self-custodial wallet, they have to enter the private key and sign the transaction themselves, without depending on any trusted third party. While this offers immense security and user privacy, non-tech-savvy users face high friction when it comes to using self-custodial wallets.

Non-Custodial Wallets

Non-custodial wallets strike the middle ground between custodial and self-custodial wallets, making them an ideal choice for new web3 users. In non-custodial wallets, private keys are neither managed by a third-party nor users. Instead, private keys are stored in a distributed fashion, secured by cryptographic mechanisms wherein multiple parties contribute to calculating a shared public and private key pair. Although users aren’t tasked with managing their private keys when using non-custodial wallets, they can still export the private keys whenever needed.

Custodial vs Self-Custodial vs Non-Custodial Wallets

To start with, custodial wallets are easy to use for just about anyone who is tech literate. They tend to come with a simple user interface and offer a hassle-free user experience. Users can regain access to the wallet account upon forgetting the login id or password. The same is not true with self-custodial wallets. If the seed phrase is lost, a self-custodial wallet cannot be accessed forever, and all the assets held through the wallet are essentially lost. Moreover, having to set up wallets and manage mnemonic phrases might end up becoming overwhelming for new web3 users. This is especially relevant in cases where users need to sign up on dApps through their crypto wallets.

Custodial wallets are easy-to-use but come with a higher risk of privacy and security. While self-custodial wallets offer better security and privacy, they aren’t quite intuitive for new users to use. Non-custodial wallets, at this juncture, offer the best of both worlds. They are more user friendly than self-custodial wallets and offer better security than custodial wallets.

In summary, self-custodial wallets are the way to go for web3 and crypto savvy users looking to go the extra mile of managing their seed phrases. Non-custodial wallets, on the other hand, are right for just about anyone, starting from a novice web3 user to a dApp developer.

We at Arcana have built our very own embedded non-custodial web3 wallet. dApp developers looking to onboard new users can simply integrate our Auth SDK and leverage the embedded non-custodial web3 wallet to store and manage users’ private keys. Arcana’s DKG (Distributed Key Generator) relies on a cryptographic mechanism through which multiple parties contribute towards generating public private key pairs. As of now, our non-custodial wallet can be used for all EVM compatible chains, including ours.

Learn more about our web wallet here: https://docs.beta.arcana.network/docs/category/using-arcana-wallet

About Arcana Network

Arcana is Web3 infra for devs to launch and scale apps through its Auth, Store, and Access SDKs. Web3 apps use Arcana’s SDK to authenticate users with Social and Passwordless Auth and create non-custodial wallets, Store Encrypted/Unencrypted Data, and Manage Access. Built for Ethereum and EVM-based chains, with Arcana’s privacy stack, developers can build secure and privacy-preserving apps with a seamless user experience.

Arcana has raised 2.7Mn USD from some of the leading investors and founders in the ecosystem, such as Balaji Srinivasan, Founders of Polygon, Woodstock, Republic Crypto, and Digital Currency Group.

Watch out for Arcana’s upcoming Mainnet in December 2022. Want to know more about our Mainnet features? Book a demo.

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