This blog was co-authored by: Preshanta Poonan, Associate Designate
Bitcoin started the cryptocurrency frenzy in 2009, and since then there have been several new cryptocurrencies launched which are fast growing in interest and adoption. When purchasing cryptocurrency, it is important to understand how the wallets work that store your crypto. You must choose the right type of wallet to store your cryptocurrency and ensure its safety.
In this article we break down some of the tech jargon, to help you decide which type of wallet is best suited for your purposes.
What are crypto wallets?
A crypto wallet is a digital wallet that enables users to store and manage their cryptocurrency. A crypto wallet allows transfers in cryptocurrencies to and from other wallets. It is similar to your online banking account that stores your fiat money for you, and allows you to make or receive electronic transfers to and from other bank accounts.
What are private keys?
A private key is a secret number that is used in cryptography, similar to a password. In cryptocurrency, private keys are used to sign transactions and prove ownership of a blockchain address. Unique private and public keys are assigned to your cryptocurrency wallet.
In order to take crypto out of your wallet you will need to use your private key. Your private key must never be shared with anyone else and must be kept safe and securely. However, if you lose your private key, you cannot phone the bank to help you get back into your account. There have been many stories of people misplacing their private keys resulting in hefty losses. James Howell in the UK mistakenly threw away a hard drive that contained the private keys to 7,500 bitcoins in 2013. That would be worth approximately R4.9 billion today. He wants to try and look for it in the local landfill, but he has not been able to get permission yet from his local council.
You give your public key to those that want to send money to you. Similar to sharing your bank account details in order to receive an electronic transfer.
Cold v hot storage
Cold wallet or cold storage is an offline wallet used for storing cryptocurrency. A hot wallet is a cryptocurrency wallet that is always connected to the internet and cryptocurrency network.
It is best practice for wallets that are not in regular use to be stored in cold storage.
Custodial v non-custodial
There are two types of wallets, namely custodial and non-custodial wallets. The main factor to distinguish between a custodial or non-custodial wallet is who holds the private key.
- A custodial wallet is defined as a wallet in which the private keys are entrusted to a third party. This allows the third party to have full control over your funds while you only have the ability to send or receive payments through the third party’s platform. This is usually where a purchaser of cryptocurrencies makes use of a service provider in order to buy and sell cryptocurrency. Most popular wallet providers and exchanges are custodial. This is similar to the trust relationship you have with your bank.
- A non-custodial wallet is a type of wallet that allows you to hold your own private keys and to be your own bank. You have full control over your funds that are associated with the private key. The service provider is usually an interface for the convenient managing of assets. For example, a service provider that provides hardware for cold storage.
Similar to how your online bank account can be hacked, cyber criminals can hack into your digital wallet, for example, by getting access to your private key. For that reason, it is important to choose the correct type of wallet and private key storage to best protect your cryptocurrency.
Are crypto wallets regulated in South Africa?
According to the IFWG position paper, once regulated, service providers providing custodial wallets may be considered as a crypto asset service provider and be required to become a licensed financial service provider in order to provide their services.