How do users establish an identity with a blockchain and authorize transactions to be made from their account?

Anyone can join a blockchain like Bitcoin. All it requires is to create an identity and find someone to transact with. An identity is nothing more than a large random number that each user picks for themself. As long as the user uses a system that picks a truly random number, and never reveals it, no one will be able to guess it. This is true because the field of possible numbers is so vast – more than the number of atoms in the universe – that the possibility of guessing another’s number is effectively impossible.

Using cryptography, this secret number is used to create a family of new numbers. A new related number is generated for each transaction. Each new number is used to generate a public/private key-pair, so each transaction has a unique authorization point. Done in this way, an entire transaction history can be recreated from just the root number. The standards that define this are found in bip-32, bip-39, bip-43

How does a user keep track of all of these numbers?

A “wallet” is used to keep track of these numbers for the user. Wallets are software applications or hardware devices that abstract away the math and the numbers, making it easier and more natural for the user to interact with each blockchain network.

Wallets are your therefore gateway to blockchains. In addition to sending tokens, you can do many other things. Wallets can manage collectibles, coordinate membership in DAOs, stake, trade, farm, swap, and a myriad of other use-cases, to be discussed later.

Wallet Types

There are several ways to classify cryptocurrency wallets.

  • custodial vs. non-custodial
  • software vs. hardware
  • browser vs. standalone
  • single-signer vs. multi-signer
  • direct vs. account-abstracted

Wallet Diagram

Custody refers to who actually holds the keys.

In a custodial wallet, an entity like an exchange maintains the keys for the user. The advantage is that the user does not have to worry about lose them. The disadvantage is that the user must trust the security of the exchange.

All exchanges offer custodial wallets. (Some even offer non-custodial wallets as well.)

In a non-custodial wallet, like a browser wallet or a hardware wallet, the user maintains possession of the keys. The user is a smaller entity than an exchange and therefore may not be targeted by hackers as directly. But safely custodying one’s keys is still a very significant responsibility. It is quite a technical matter at this stage as well. If you lose your then, there is no way to ever get them back.

In the category of non-custodial wallets, there are two types: software and hardware.

Software wallets are applications that run on your computer or phone. The most popular software-based wallets are browser plugins like Metamask. Browser plugin wallets are convenient because they can automatically interact with the websites that you visit, once you give them permission. Browser plugins typically support one network family at a time, like Ethereum or Solana. Desktop application wallets like Exodus typically support the majority of cryptocurrencies in one package and are convenient for managing a whole portfolio. They provide a beautiful interface with many useful features.

A hardware wallet is a separate hardware device, sort of like a flash drive. It has a screen and some buttons and it’s sole purpose is to manage keys away from internet connected devices, where they are most easily stolen. The hardware wallet never shares the keys with the computer or phone that it interacts with. Instead it sends only the signatures that authorize transactions, which can only be generated on-device.

Some hardware wallets:

There are other ways to self-custody as well. Services are emerging that are trying to make this process safer and easier. A service like Casa help the user to create a multi-signature wallet, where no one signer can run off with the funds, and having multiple signers allows for key recovery in the case of loss.

MPC, or multi-party-compute, is a new technology that is improving the way enterprise-grade multi-signer accounts work. With traditional multi-signer paradigms, the keys have to be generated in one place and distributed to the holders. Keys are most vulnerable when they have to be moved. MPC allows each party to generate their own key in place. They can then interact with their group of signers without transmitting any sensetive information. This technology will help make both custodial and non-custodial wallets more secure.

“Account abstraction” (AA) is a new paradigm that is being actively researched. In this case, a smart contract would maintain a set of rules that governs access to a wallet. With AA, it is possible for new service providers to emerge that can provide key recovery and other useful services, without the user having to give up control of their keys. It has the potential to make wallets both user-friendly and safe for use by technical and non-technical a like.

Wallet landscape:

Any wallet can send tokens and messages to any other wallet, as long as they support the same networks. The type of wallet you choose will depend on your use case and security preferences. This most common practice among security-conscious enthusiasts is to self-custody a majority of funds in a hardware wallet, while keeping some funds in a browser wallet or exchange for quicker access.

As with all things in this space, there are always important tradeoffs to consider. The highly technical nature of the space precludes more people from getting involved. But the technical barriers to entry will hopeful come down over time.

The most important thing about wallets…

If you lose your wallet, are all your assets lost?

Not necessarily. First of all, the wallet does not store any of your assets – that information is all stored on the blockchain itself. Your wallet only stores a copy of the keys that permit you to transact with them.

Wallets always provide a way to back themselves up. This usually involves writing down a set of words that acts as a recovery phrase. Always take the time to record your recovery phrases and store copies in one or more safe locations.

Additional Resources

What are Crypto Wallets | Simply Explained

More info from Coinbase

custodial and non-custodial