The explosive demand for crypto currencies has led to a surge in speculative valuation. Most non-technical investors keep their funds within a crypto exchange (such as Coinbase or Binance) that offers a web-accessible wallet. This arrangement is familiar, much like online banking offered by many reputable, financial institutions. The ‘wallet’ analogy works well for other types of digital assets. Apple Wallet keeps airline tickets, gift cards, and other important digital codes. In the software sense, a ‘wallet’ affords management of a digital asset. The analogy holds that much like a paper wallet, the data is held ‘inside’. A lost iPhone seldom means an item is lost forever, as it’s common to reprint an airline boarding pass or loyalty card.
However, a crypto wallet is much different. The “wallet” analogy does not cleanly extend to crypto tokens, and glosses over the capabilities and danger of treating it with the same mindset.
Where’s my money?
A crypto wallet does not hold coins at all. Your coins are locked up on the globally distributed blockchains of whichever cryptocurrencies you hold. The Bitcoin, Ethereum, Litecoin, etc blockchains are all wholly different structures that are globally maintained by decentralized networks of computers. There is no single blockchain.
If coins are on the blockchain then what is in a wallet? A wallet is a collection of private keys to the blocks that contain the coins on the blockchain. This is not unlike keys to several safe deposit boxes containing cash. If a private key is lost, it’s nearly impossible to unlock coins. Assuming a 256-bit key, the norm for cryptocurrencies, there are more possible key combinations than the number of atoms in the universe.. In other words, once it’s gone, it’s gone.
With cryptocurrencies, there is no ‘help desk’ to call for a lost private key. Careful management of this digital asset is extremely important, and proper care of private keys is precisely the role of a crypto wallet.
Cover Your Keys
If you are a user of the most popular crypto exchange Coinbase, private key management is handled by the exchange. A currency-specific crypto ‘address’ is provided, and people anywhere in the world can send coins. This is fine, but what happens if Coinbase or your chosen exchange goes out of business? What happens if the exchange is unreachable due to network trouble or a natural disaster? An exchange is an enticing target for state-sponsored hackers. In the United States, the federal government insures bank deposits up to $250,000. There is no federally backed guarantee with cryptocurrencies and exchanges are not perfect. In 2011, the largest Bitcoin exchange of the time, Mt. Gox, was hacked and an estimated $450 million stolen from the exchange’s hot wallet. The company has since gone bankrupt. In early 2018, Coincheck was hacked for an estimated $530 million. However with this hack, customers are set to be repaid. An exchange-managed wallet may be convenient, but if you don’t control the private key, your coins are not really your coins.
Exchanges provide liquidity and a convenient way for traders to enter and exit the market. These roles are integral to a well functioning marketplace. However, storing an entire portfolio of crypto within exchange-managed wallets exposes you to undue risk. It is recommended to keep any crypto you do not plan on actively trading within a separate wallet where you control the private key. So what are our opinions for a crypto wallet?
A hardware-wallet is a separate device specially designed for the physical, and computational protection of cryptographic keys. The added security of two-factor authentication and secure computation within a ‘secure enclave’ make hardware wallets the most secure way to protect private keys.
The hardware wallet provides a ‘safe space’ for the private key to be utilized within memory. On your iPhone, this special area is called the ‘secure enclave’ and is used to store biometric information (like fingerprints and facial recognition.) Unfortunately, iOS does not natively support the required cryptographic algorithms used by Bitcoin, Ethereum and others; so it cannot be used yet as a true hardware wallet.
The current selection of hardware wallets are about the size of a standard USB stick. What happens if such a tiny thing is lost? Fortunately, there is a backup plan. While the hardware wallet contains all the private keys necessary to unlock coins on the blockchain, it is possible to regenerate these keys from a ‘master’ key. The BIP-39 spec requires a 12 or 24 word mnemonic that is used to create the ‘master’ key from which all other keys are derived. You can read more about this fascinating crypto standard here. With a BIP-39 wallet, you must write down the mnemonic words during setup and keep it in a safe place. If the hardware wallet fails, it is impossible to recover the keys, and all funds are locked forever. It’s a curious fact that the security of a hardware wallet depends on the security of mnemonic words written on paper. If an adversary gains access to these words, they can steal all funds, and all future funds to be held within this wallet. Encrypting this list with another key is common practice as well as storing within a bank safety deposit box. The Recommended hardware wallets support ‘deterministic’ key generation and support crypto standards BIP-32, BIP-39, BIP-43, and BIP-44. The technical details are not important to the user, but something to check for when choosing a proper hardware wallet.
Software wallets are more convenient than hardware wallets. While it does expose the private key to eavesdropping by a hacker, a software wallet such as metamask allows interaction with a blockchain enabled webapp. (In the case of metamask, an Ethereum-enabled dApp) However, a software wallet is merely a piece of software. If a computer is compromised with a keylogger, or a program that can read arbitrary pieces of memory, an attacker can drain the account. Software wallets manage a list of private keys just like a hardware wallet. The biggest risk is hard drive failure (which is why it’s always important to backup those keys). Software wallets can also employ BIP-39, but because of the sensitivity of the ‘master’ key and and exposure to rogue programs, hardware wallets are preferred for maximum security.
A private key is simply a stream of bits. This stream of bits can be represented as text, and could be tattooed between your toes, written to a microchip and implanted, or simply printed out on paper. ‘Paper wallets’ are exactly this: a private key printout meant to be placed in a safe deposit box, safe, or buried on a deserted island. The tradeoff of a paper wallet is higher security at the cost of convenience. The public address of a paper wallet can act as a ‘long term savings account’ with the expectation funds will not be used from this account in the short term. Only the full amount should be transferred from a paper wallet due to the way some wallets generate separate ‘change’ addresses. The balance remaining could potentially be saved on a different private key, rendering the paper wallet worthless. The Winklevoss twins, who are famous for their involvement in proto Facebook and subsequent litigation against Mark Zuckerberg, have been buying Bitcoin since 2012, and now hold a fortune over $1.2 billion USD. To manage this massive fortune, they reportedly keep one half of each paper key in a different safe deposit box. When money is involved, one cannot be too careful with cryptographic keys.
Fiat bank accounts allow ‘approved signatories,’ control through a joint account. This notion is available through multi-signature wallet. The wallet acts just like a normal software wallet, but for added security, a wallet will not send a transaction until the designated number of signatories approve the transaction. Security and control can be further enhanced with daily withdrawal limits and delayed payouts. A wallet is software, and any unique situation that involves the disbursement of funds can be accommodated by a programmer.
Crypto is still in a nascent stage, and there are many more advances in wallet technology on the way that will simplify keeping your crypto holdings safe. Regulatory changes could also provide additional protection for consumers. For now, it’s your responsibility to keep your funds safe with the available tools. The choice of hardware, paper or software wallet depends on your needs and how you plan on deploying capital. It is ironic that a non-physical stream of bits should be so difficult to keep safe and conveniently available. The problems we have today with safety and availability are not unlike those of ancient times; where gold was only as safe as it was hidden or guarded. At least in those times, a fortune could not become locked forever due to a misplaced key! Above all, own your private key, and use a blended means of hardware, paper and software to meet your needs of convenience and security.