For anyone who is new to crypto, it’s important to understand that this digital cash system works differently from all previous forms of online payments. First of all, you’re obviously transferring bitcoin on the network rather than traditional, government-issued currency. Additionally, the system works much more like cash in the real, physical world rather than credit card payments or bank transfers. In other words, ownership over bitcoin is who is holding the asset rather than a centralized third party. The benefit of a system where users have complete sovereignty over their own assets has its pros and cons.
Full control means greater levels of censorship-resistance on payments and seizure-resistance on the assets themselves. However, users are also now completely responsible for the safety and security of their digital money. Due to this key difference in how Bitcoin works compared to previous online financial systems, it is vital that users understand Bitcoin security and concepts such as private keys. After all, there is no customer service hotline to call in a decentralized system like this.
Bitcoin works on a system of private keys that allow users to access coins on the blockchain. In other words, the person who holds the private keys associated with a particular set of bitcoin is the only one able to move those coins. These private keys are effectively nothing more than strings of random numbers and letters. Therefore, the private keys can take storage anywhere a string of alphanumeric characters can be stored. This means a desktop computer, a mobile phone, a zip drive, or even a piece of paper.
There are also special hardware devices built for bitcoin private key storage known as hardware wallets. Due to the reality that users are holding private keys rather than actual bitcoin in their wallets, some say that it would be better to refer to them as keychains. This analogy may continue to make more sense as the crypto space evolves and other data, such as digital identities and non-fungible tokens, become tied to these same private keys. In other words, Bitcoin wallets may be about much more than just money in the future.
While private keys can store in a wide variety of mediums, most people are referring to Bitcoin software that allows for transactions to be made when referring to a wallet. That said, the most secure types of bitcoin wallets are those where cold storage is enable. This is basically any type of bitcoin wallet where the private keys are not exposed to the internet. Examples of this type of bitcoin wallet would be paper wallets and hardware wallets.
Crypto Banks are Not Bitcoin Wallets
The main benefit of Bitcoin is that it gives users full control over their digital assets. However, the reality is most people don’t take advantage of this feature. For better or worse, the biggest use case for bitcoin right now is to basically gamble on the future price of the crypto asset. For this reason, many users store their coins with a trusted third party. This is usually a crypto exchange, but there are also bitcoin institutions that act more like traditional banks.
Some say that handing one’s private keys over to a third party misses the point of Bitcoin. However, it’s important to remember that these centralized institutions are able to create a much more user-friendly experience. Bitcoin wallets connecting directly to the blockchain can still be a bit too difficult for your mom or dad to use, so exchanges and digital banks can help bridge the gap in that department. On the other hand, crypto exchanges have become notorious hacking targets over the years. The large number of bitcoin exchange hacks, some of which were inside jobs, is what has led to the popularity of the phrase, “Not your keys, not your coins.”
One should note that there are secondary protocol layers in Bitcoin. These are a sort of middleground between bitcoin banks and bitcoin wallets. For example, federated sidechains put user funds in a multisig address controlled by a variety of parties. This is rather than one, single entity. This makes loss of funds much less likely. Especially as a number of usually-competing entities would have to collude to steal the funds. RSK and Liquid are two federate sidechains that are active today. Minimint and federated Lightning Network channels are two other upper-layer protocol layers that rely on federated custody of user assets.
Of course, the Lightning Network is another protocol layer build on top of the base Bitcoin blockchain. It enables different features without handing custody over to a federation. Instead, users effectively peg their coins into a faster, cheaper payment layer built on a variety of smart contracts where cheating is extremely difficult.
Crypto Wallets Continued
There are also so-called light clients. These are also popular in Lightning-enabled wallets. They rely on bitcoin miners to do much of the work involved with verifying the integrity of received transactions. As long as the majority of the miners on the network are honest, a light client can assume that a bitcoin payment they have received is authentic.
All of these different Bitcoin protocol layers can integrate into wallets. It is important to have a strong understanding of the Bitcoin network stack. Different wallets may come with different sets of tradeoffs. This is depending on the various ways they interact with the base Bitcoin blockchain and other, upper-layer networks.
This disclaimer informs readers that the views, thoughts, and opinions expressed in the text/sponsored content belong solely to the author, and not necessarily to Bitcoin of America, organization, committee or other group or individual. All investments are at your own risk and should be done after careful research.