Why is it so important?
Well “owning” cryptocurrency is somewhat of a misleading way of thinking about it.
When we talk about Bitcoin ownership we really just mean that you have access to a secret number, commonly known as a private key, that can be used to mathematically prove that you have control of said Bitcoin.
Receiving bitcoins, and subsequently sending or storing them, involves mathematical steps that involve the private keys. These steps are complicated with lots of room for error, so we use Bitcoin wallets to manage the keys in the background, which makes it easier and safer for users to receive, send, and store their bitcoins.
This article explains how Bitcoin transactions actually work and breaks down why we use Bitcoin wallets to manage our private keys and transactions, and describes the common types of wallets. For even more information check out our guide to the best cryptocurrency wallets.
What is a Bitcoin Transaction?
A Bitcoin transaction is the transfer of coin ownership from one person to another. Transactions contain two types of information: inputs and outputs. A transaction input is where the sender uses their private key to prove ownership of an existing coin, allowing them to spend the coin. A transaction output is where the sender creates a new coin and locks its ownership to whoever possesses a separate private key. Single transactions may contain many inputs and outputs.
Imagine Alice possesses the private key for a 0.08 BTC coin and she wants to give Bob ownership of 0.06 BTC. Alice creates a Bitcoin transaction with three parts:
- Transaction input: Alice uses her private key to prove she owns the 0.08 BTC coin and is allowed to spend it.
- Transaction output: worth 0.06 BTC, can only be spent by Bob’s private key.
- Transaction output: worth 0.01999 BTC, can only be spent by another private key owned by Alice (this is called the change output).
You probably noticed the transaction outputs didn’t add up to the original 0.8 BTC. The remaining balance of 0.00001 BTC will be paid as a transaction fee to whoever mines the block.
The Benefits of Wallets
It’s difficult to combine the necessary information and perform the calculations to correctly create a Bitcoin transaction. There are many steps where human error may cause a user to lose their funds. It would also be confusing and difficult to manually keep track of private keys.
We can avoid these problems by using Bitcoin wallets. Wallets help us manage our private keys and make it much simpler to send, receive, and store bitcoins. Software wallets, for example, allow us to create and use different private keys for different uses. When we want to send a Bitcoin transaction, the wallet combines the necessary information and performs the functions required to prove we own the coins that we are sending. The same is true when receiving a Bitcoin transaction.
Types of Wallets
Depending on your specific needs, there are different types of Bitcoin wallets to choose from. Each wallet comes with a set of trade offs between security, privacy, and ease of use.
A software wallet is a program that runs on a computer and provides an interface for the user to send, receive, and store bitcoin. Software wallets are easy to use, but your funds are at risk since they are stored on a computer where hackers can access them.
Hardware wallets are physical devices that store and manage private keys for users. These wallets can be expensive and they are harder to use than regular software wallets, but the private keys never leave the hardware wallets. This means there is a much lower risk of being hacked.
Since private keys are just secret numbers, they can be printed or written on paper for storage and backup. Paper wallets are generally not recommended these days, however, as it’s proven to be one of the most error-prone methods of storing private keys.
Private keys can be converted to a set of 12 words that represent the secret number. These 12 words can be memorized as a way of storing your private key. Brain wallets are not recommended because if you are unable to remember the words then your funds are lost forever.
Not Your Keys, Not Your Coins
When using the wallets discussed so far, the user is the only one with access to the private keys. These types of wallets are called non-custodial wallets because no third party has custody of the user’s funds. Conversely, custodial wallets are wallets where the user does not directly control the private keys for their funds.
A very common example of a custodial wallet is using an online exchange to store bitcoin, where the exchange has full control over your funds. There are risks associated with using custodial wallets, as numerous exchange hacks have shown us in the past.
On the other hand if you’re not very tech-savvy and would rather trust one of the reputable exchanges to hold your private keys than you might be better off with a custodial wallet.
Bitcoin transactions contain a lot of information and require complicated calculations to send and receive them. Bitcoin wallets do most of the work for you, which reduces the risk of human error and makes for a much better user experience. Be sure to carefully consider the options and trade offs when choosing a wallet, and remember – not your keys, not your coins!