Crypto wallets are the foundation of any risk management system, so it is important for you to have a good understanding of what wallets are, and their functionality.

The term "wallet" is used to describe either the hardware or software that records your cryptoasset transactions. It is a common misunderstanding, albeit helpful, for wallets to be described as hardware or software that holds your "cryptocurrencies." This is however not accurate. Unlike a normal wallet, which can hold actual cash, crypto wallets technically don’t store your crypto. Your holdings live on the blockchain. Crypto wallets, more accurately blockchain wallets, store your private key, public key, and blockchain address, communicates with the blockchain network and enables you to send and receive cryptoassets, including cryptocurrencies like Bitcoin (BTC) and Ethereum (ETH), without requiring a third party to verify the transactions.

Each wallet comprises of Public and Private Keys:

Public-key cryptography is a specialised cryptographic system that utilises pairs of lengthy alphanumeric keys that only function when used in tandem. Blockchains such as Bitcoin (BTC) use public-key cryptography to create a secure digital reference about the identity of a user with a set of cryptographic keys: a private key and a public key. The generation of these keys is made possible by the use of cryptographic algorithms based on mathematical problems to produce a one-way function.

Secure digital references about who is who, and who owns what, are the basis for P2P transactions. In combination with a transaction, these keys can create a digital signature that proves ownership of one’s tokens and allows control of the tokens with a wallet software. Similar to how passwords are used to authenticate in internet banking transactions, public-key cryptography is used to authenticate and sign blockchain transactions.

Public keys represent a wallet address, similar to your home address, that can be distributed to others i.e. Public keys public-facing data point used to identify the wallet and to receive inbound cryptoassets, such as NSIL 10|10, and encrypt outbound transaction data. When transferring cryptoassets into a wallet, you simply input the public key as the destination address.

Private keys is like the key to your front door and is therefore to be known only by their owner. It is used used to facilitate the transfer of cryptoassets out of a wallet and prove ownership over any cryptoassets held inside i.e. Private Keys are used to authenticate asset ownership, grant access to cryptoassets' digital reference and encrypt the wallet. While anyone can send transactions to the public key, you need the private key to “unlock” them and prove that you are the owner of the cryptoasset received in the transaction.

In summary: Your keys prove your ownership of your cryptoassets and allow you to make transactions. If you lose your private keys, you lose access to your cryptoassets.

This short video is a good wallets explainer video:

Important to note: An unauthorised person who gains access to a wallet’s private key can effectively take control of the assets inside the wallet and move the assets elsewhere, to other wallets that they control. Unlike traditional finance , there’s no way of reversing the transaction without rolling back the blockchain – something that very rarely happens in the industry.

Custodial vs. Non-Custodial Blockchain Wallets:

There are two different types of wallets:

Custodial wallets are wallet services offered by a centralised business such as a cryptocurrency exchange. Custodial wallets have certain benefits, such as less user responsibility regarding private key management. When a user outsources wallet custody to a business, they are essentially outsourcing their private keys to that institution. The individual user is not responsible for protecting the private key to the wallet and therefore places trust in the business keeping the private key safe. When a user wishes to send coins out of a custodial wallet, they simply log in to the platform with a username and password, input the public key of the location to where they wish to send cryptoassets, and the business is responsible for inputting the private key to complete the transaction. This creates an extremely simple solution for the user but also creates an additional layer of risk e.g. exchange hacks and the freezing of assets by centralised authorities i.e. the weaponisation of finance (a controversial topic to say the least).

Non-custodial wallets do not have this exact risk. Non-custodial wallets do not require the outsourcing of trust to a centrally controlled institution, so no institution can refuse to complete transactions or sieze your assets. These transactions are essentially censorship-resistant, as the user (you) controls the private key. However, non-custodial wallets are not as easy to use as custodial wallets. When using a non-custodial wallet, users must remember that if they lose the private key, the cryptoassets in the wallet are essentially lost forever. Misplacing private keys can be a costly mistake. Users must develop a set of practices to maximise security and protect private keys in order to enjoy the full benefits of a non-custodial wallet.

This short video is a explains the difference between custodial and non-custodial wallets:

Voshmgir, Sherman, 2021 - 'Token Economy: How the Web3 reinvents the Internet.'

Coindesk, 2022 - 'Custodial Wallets vs. Non-Custodial Crypto Wallets'