Sometimes there is a little confusion about what a wallet can and cannot do, so we will start with what it can’t. Wallets generally don’t allow you to buy cryptocurrencies, that is what exchanges are for. All exchanges provide you with wallets to store your funds in until you withdraw them, but wallets usually don’t provide you with an exchange service.
A wallet is a program that has four main functions:
- Generating, storing and handling your keys
- Generating addresses to receive funds
- Showing you your balance
- Creating and signing transactions to send funds
The first function is the main function and main differentiator of all wallets: generating, storing and handling your keys. As we said in the last article about identity on a blockchain, having access to your private keys means having access to your funds.
Where you store your keys determines the safety of your funds and at the same time the convenience of using them. With wallets there is a trade-off between safety and convenience: Having some funds on your mobile wallet (your smartphone) makes them easy to spend, but not very secure. Keeping larger amounts on a hardware wallet is very secure, but not as convenient to spend.
We would like to introduce another abstraction, that helps with wrapping one’s head around the concept of your keys and the importance of their safety.
A Wallet Acts as a Keychain
It might be more intuitive to think of your wallet as a keychain, rather than an actual wallet. The term wallet can be misleading. To make it crystal clear:
You never actually store any funds in your wallet, just the keys to access them.
The blockchain records the amount of coins associated with a specific key pair (your identity on the blockchain). It knows the amount of funds the keys have because it stores all the transactions that have ever occurred. Say you receive 10 ZEN in a transaction and receive another 10 ZEN in a later transaction. It is clear that the owner of the key pair has 20 ZEN if you look at the transaction history.
You need the keys stored in your wallet to move funds. This is why a keychain feels like the most accurate analogy. If you don’t control your keys, you don’t control your funds. You don’t need to understand how everything works in detail to use cryptocurrencies. The concept of your keys giving you access to your funds is still important to remember.
Wallets create a layer of abstraction and are becoming more and more user-friendly. Wallets show you your balance, generate an address to receive funds by just clicking “deposit” or “receive”, and provide you with a simple interface to send funds. All you need to do is enter the address that you would like to send the funds to and the amount you want to transfer. The signing procedure will happen in the background when you click send.
What if I Lose My Keys?
Being permissionless comes at a cost. You don’t have to ask anybody to join the network and you don’t have to register with a central authority. Being able to do this comes at the cost of you being responsible for the safety of your funds. There is nobody that can help you recover your keys if you lose them. You may have heard stories about people searching for old hard drives because they have “lost their Bitcoin”. More accurately, they lost the keys to access their bitcoin.
If anybody was able to recover your keys for you, they would also be able to steal your funds. This would eliminate the trustless aspect of blockchains.
There is a sort of recovery mechanism with many wallets called a mnemonic phrase or backup phrase. A mnemonic phrase usually consists of 12 or 24 words. With these words, you can recover your keys. You receive your mnemonic phrase when you install and setup your wallet. Be sure to write it down on a piece of paper and keep it in a safe place. You should have at least two versions of your backup phrase stored in a different location.
It’s essential to understand that your backup phrase is as important as your private key itself. If anybody gets their hands on your backup phrase, they can steal your funds. Saving it as a screenshot or text file on your computer is not a good idea.
We can say that a wallet is a program that helps you manage your keys and create transactions in an easy way. Your wallet looks at the blockchain to determine how much funds you own by reviewing the transaction history. To send funds it writes a transaction and signs it, meaning the wallet encrypts it with your private key.
Try our wallet, Sphere by Horizen, and visit our Faucet to become more comfortable with the concepts we covered in this section. You will get a small amount of free ZEN, which you can use to receive and send your first cryptocurrency transactions without having to sign up or register anywhere. Simply install Sphere by Horizen, create a wallet (and save your Recovery Phrase on a piece of paper), provide your address to the Faucet and after a few minutes, you will have your first Coins to play around with!
See our intermediate section for an overview of the different types of wallets.