What Is A Bitcoin Wallet and How Does it Work?

Bitcoin was the first ever cryptocurrency, and therefore the first network to support crypto wallets. The first wallet ever created belonged to Bitcoin’s founder, Satoshi Nakamoto. The second wallet belonged to Hal Finney, a friend of his. When Nakamoto sent Finney 10 Bitcoin as a test; no one knew the significance this technology would have.

However, since then, we’ve witnessed many advancements in the realm of both crypto and crypto wallets— even for the oldest network Bitcoin. To explain, with time the Bitcoin ecosystem has grown immensely. Today, Bitcoin wallets are much more complex and capable than Satoshi’s first wallet.

If you are new to crypto, you might be wondering how a Bitcoin wallet works, or possibly, how you can set one up yourself. In this article, we’ll dive into all of those specifics and much more. But before we get there, what is a Bitcoin wallet exactly?

What Is A Bitcoin Wallet? 

In the simplest of terms, a Bitcoin wallet is something that allows you to hold, send, receive, access, and manage Bitcoin (BTC). You can think of them much like the wallet you carry around in your pocket apart from the underlying tech is a bit more complicated. 

See, Bitcoin wallets don’t actually store Bitcoin. Your cryptocurrency is always stored on the blockchain. Your Bitcoin wallet’s purpose is to generate and store private keys that allow you to access and manage different Bitcoin accounts.

Let’s take a closer look at how Bitcoin wallets work.

How Does a Bitcoin Wallet Work? 

Bitcoin Wallets use Public and Private Key Cryptography 

Like most crypto wallets, Bitcoin wallets use public and private key pairs. To explain, within each wallet, you can generate a near-infinite number of public and private key pairs managing an equally large number of blockchain accounts across multiple networks. 

The private key is a long sequence of characters, and it gives the owner access to a specific account. So, if you want to move any funds out of an account, you would need to control the associated private key. Since anyone with that key has access to the account, the private key must remain private and secure—just like it sounds.

Your public key, on the other hand, is completely safe to share. In fact, you’ll need to share this public key if you want to receive funds from anyone. Essentially, your blockchain address is just a translated version of your public key, making it easier to read and share.

Bitcoin Wallets are Hierarchical Deterministic Wallets 

In the past, non-deterministic (ND) Bitcoin wallets used to generate random key pairs for receiving and changing addresses. However, they were not related to each other. This resulted in users having to write down every single private and public key individually. And store them somewhere safe–a logistical nightmare!

Bitcoin Improvement Proposal 32 (BIP 32) provided the solution to this impracticality in 2013. In short, it introduced a hierarchical tree-like structure for wallets, wherein a random number called the entropy is the foundation, branching out into private keys for different cryptocurrencies. To clarify, the entropy is a very random number—one that is practically impossible to guess. An HD wallet uses this number to generate a near infinite number of private keys that all relate to that original number. Plus, each public key is derived from a private key using a trapdoor function. That means it’s very easy for the private key to point to the public key, but nearly impossible for someone to work out your private key with the public key. 

This hierarchical structure means HD wallets essentially allow you to share your public key while your private key stays private, using the same information to generate both. In addition, the BIP-39 standard also introduced the secret recovery phrase, a way to easily translate the entropy with a simple mnemonic. That means that you can recover every single private key using just the secret recovery phrase.

Bitcoin Wallets UTXOs 

But what happens to the coins during a transaction? Well BTC in particular uses the UTXO model. So, what is a UTXO exactly? 

UTXO simply stands for ‘Unspent Transaction Output’. Essentially it’s like the Bitcoin network’s version of change. In short, each crypto transaction has an input and output, and when the input is processed, it produces an output: the UTXO. 

Let’s use a real-world example to see how it works.

Say you want to buy a loaf of bread for $2, but you only have a $10 note. In this case, you must give the vendor the entire note and receive the $8 in change. Similarly, with the UTXO model, you cannot send a specific or smaller amount from a UTXO. You must send the whole amount and receive a smaller UTXO in return. However, unlike with that loaf of bread, this entire process is governed by blockchain protocol. That means you don’t have to put trust in a person to return your change.

Types of Bitcoin Wallets

Exchange Bitcoin Wallets (Custodial Crypto Wallets)

Exchange Bitcoin wallets, also known as custodial wallets, are usually offered by centralized crypto exchanges, and while they allow you to manage BTC, they don’t offer true ownership. That’s because instead of letting you manage your private keys yourself, the intermediary manages the private keys for you—only letting you access and manage the account rather than own it. 

Pros:

• Easy to set up and manage
• Free to set up and use

Cons:

• Don’t offer you true ownership: the entity offering the wallet retains the ownership of your funds.

Software Bitcoin Wallets

Software Bitcoin wallets include applications for desktop and mobile devices. These types of crypto wallets are installed on a desktop, mobile, or laptop computer. Software Bitcoin wallets can access your crypto, make transactions, display your balance, and more. Further, some software Bitcoin wallets include enhanced functions, like exchange integration.

They come in several types including mobile Bitcoin wallets, desktop Bitcoin wallets, and browser extension wallets. Let’s explore each type of Bitcoin software wallet: 

Desktop Bitcoin wallets: installed on your computer

Desktop Bitcoin wallets are the most common type of crypto software wallet. They are simply software you install on your desktop computer, similar to how you install mobile wallets on your mobile phone. Desktop Bitcoin wallets store your private keys within the wallet’s interface on the host device, aka your desktop or laptop. This poses a risk, as your internet-connected device is always vulnerable to spyware and malware. 

Mobile Bitcoin wallets: apps installed on your phone

Mobile Bitcoin wallets are software wallets you can install on your phone. These programs allow you to interact with your crypto using your internet-connected mobile device. Mobile Bitcoin wallets are also susceptible to threats as they rely on your smartphone’s display. Unfortunately, malware can attack these sorts of apps and potentially gain access to smartphone’s screen too. In fact, some malware will even allow hackers to extract your private keys directly from your smartphone.

Bitcoin wallet extension: installed on your browser

Another type of Bitcoin software wallet includes a browser extension wallet. This is essentially an app built specifically to work within an existing browser such as Google Chrome or Microsoft Edge. In short, Bitcoin wallet extensions are unavoidably connected to the internet at all times. This makes them extremely vulnerable to online threats such as hacking.

Software wallet Pros and cons

Pros:

• Easy to download and install
• Free to use and manage
• Offers you ownership of your funds

Cons:

• Stores your private keys in an environment that could be accessed remotely via an internet connection

Bitcoin Paper Wallets

If you’re looking for a more secure method of storing your crypto, paper wallets offer another option. To explain, paper wallets are literal physical stores of private keys, often represented by a QR code. In fact, paper wallets are the earliest form of crypto wallets, with early crypto adopters writing or typing each of their keys on paper. These then evolved to include QR codes. However, as paper wallets are easily lost or damaged, they don’t offer a very practical crypto storage solution. As a result, they are no longer widely used.

Pros:

• Free to use and manage
• Offers you ownership of your funds
• Air-gapped from your internet connection, protecting you from online threats
•  Immune to smart contract threats, remaining entirely offline.

Cons:

• Hard to manage: you will need a separate paper wallet for each account you have.
• Not capable of interacting with smart contracts or blockchain apps.

Bitcoin Hardware Wallets

At this point, it’s important to note that the terms ‘hardware wallet’ and ‘cold wallet’ are often confused, but they are not the same thing. Hardware wallets may act as cold wallets, but only if you use them in a specific way. If you connect one of your hardware wallet’s accounts to a smart contract, it’s no longer cold.

Thus Bitcoin hardware wallets, like other types of Bitcoin wallets, allow you to sign transactions and manage private keys. However, they offer a much more practical way to manage private keys than software or paper wallets. To explain, a hardware wallet is a physical device that stores your private keys isolated from an internet connection in a secure computer chip.

Bitcoin hardware wallets protect against online threats by keeping your private keys away from your internet-connected device. Not only that, you can also manage multiple accounts using a single device. In addition, hardware wallets that support Bitcoin often support multiple other networks too. Thanks to secret recovery phrases, you can manage all of those accounts—for Bitcoin and multiple other networks—with ease. You just need to keep that mnemonic safe.

Since these types of crypto wallets are very secure and can manage a near infinite number of accounts, they are generally regarded as the best option. To clarify, if you want to manage multiple Bitcoin accounts and access the wider Bitcoin ecosystem, a hardware wallet is your best option.

Pros:

• Easy to use
• Offers you ownership of your funds
• Allows you to manage a near infinite number of accounts with a single device.
• Air-gapped from your internet connection, protecting you from online threats
• Capable of interacting with a range of Bitcoin apps and services.

Cons:

• There is an initial cost: you have to buy a physical device to manage your accounts.

How To Choose a Bitcoin Wallet

Choosing the right Bitcoin wallet for you can be a confusing process. Here are some key factors that you should take into account. 

Custodial Vs Non-Custodial Wallets

With a custodial wallet, your private keys are held by a centralised entity. This means that the entity has full control over your funds. You only have permission to use the Bitcoin wallet—you don’t actually own it. That means if that centralised entity, such as an exchange, becomes bankrupt, your funds may be at stake. 

With a non-custodial wallet, such as a software or hardware wallet, only you have control of your private keys using your secret recovery phrase. This means you are your own bank: even if the wallet provider you use shuts down, you can restore your wallet on a different interface using your secret recovery phrase. That’s because your crypto is stored on the blockchain—not within a specific crypto wallet This lets you truly take control of your assets.

Bitcoin Wallet Security: Where are Your Private Keys?

Perhaps the most important consideration when choosing your Bitcoin wallet is understanding where your private keys are stored. Private keys give access to your account, so you need to know who has access to these keys.

With crypto software wallets, the keys are typically stored on the host device. With these sorts of Bitcoin wallets, your keys become vulnerable to the security of your internet-connected device. If you fall victim to malware, your keys could be at risk.

In contrast, hardware wallets store your private keys offline in a computer chip. This means that your keys are safe from online threats – including revealing your key when signing, and the threat of malware on your host device.

Supported Crypto Assets or Necessary Functions

Another key fact to consider is that different Bitcoin wallets serve different purposes. For example, if you want to store Bitcoin ordinals, you need a compatible wallet. Additionally, if you’re looking to access certain DeFi platforms, research which wallets are compatible with your platform of choice, as they may only accept certain wallet types.

A Wallet’s Reputation

Not all Bitcoin wallets are built the same, and some are more secure and trustworthy than others. So, take the time to read reviews about user experience and security. Pay attention to any wallet hacks, and avoid those that have experienced serious breaches in the past.

Many software wallets have experienced serious vulnerabilities in the past. In fact, some have even resulted in users losing funds before they were noticed. Even hardware wallets can face challenges too, with some of the most popular devices failing to withstand certain attacks.

To this day, Ledger has never been hacked. This is due to the combination of the secure element, which stores your private key and is tamperproof; offline transaction signing, which protects you from revealing your private key; and rigorous Donjon testing.

Wallet Backup Options

Your crypto wallet is only as safe as your backup. With a hardware wallet, you can create a physical backup of the same wallet by importing the same secret recovery phrase into a second device. So, if you lose one wallet, you still have access to your assets through your backup. Additionally, hardware wallets also provide you with a physical card to write down your secret recovery phrase.

If you want to protect your SRP further, Ledger also offers the ‘Billfodl’ – a solid steel case to store and protect your secret recovery phrase, resistant to fire, water, and more. Finally, another way to backup your secret recovery phrase is by using paid optional service, Ledger Recover. This method means you can access your wallet without your SRP, wherever you are.

What is the best Bitcoin wallet?

The best Bitcoin wallet for you depends on what you want to use your wallet for. Remember, if you want to store Bitcoin ordinals, then you’ll need a wallet that supports these specific assets. Similarly, if you want to access the Lightning network, a Bitcoin layer two network, you will need to have a specific wallet capable of accessing that network. Then, there are also multiple other features you may need from a Bitcoin wallet. 

For example, if you want to keep any significant amount of Bitcoin secure, it’s recommended to use a hardware wallet that will keep you safe from online threats. Then if you want to manage a wallet with multiple people, you might need a multi-sig wallet.

In short, the best Bitcoin wallet depends entirely on what you want to do with it.

Why Ledger Wallets are Perfect for Managing Bitcoin

Whatever you need a Bitcoin wallet for, a great option is a Ledger device. Firstly, it offers you premium security, using a secure element chip to store your private keys far away from your internet connection. In addition, the custom operating system BOLOS ensures your apps stay separate, keeping your private keys shielded from the apps that you use. Then, the Ledger donjon thoroughly tests the devices and their software to make sure you are always protected from the latest threats via OS updates. 

Not only that, Ledger Bitcoin wallets also offer ease-of-use. Using a single device, you can manage a near infinite number of Bitcoin accounts. Plus, you can also use Ledger Live to access countless Bitcoin apps and services that all benefit from a clear signing plugin which means you can read every single transaction in human-readable language before clicking “accept”. 

Using the Ledger Live crypto wallet app also gives you access to the wider Bitcoin ecosystem, supporting layer two Bitcoin networks like Stacks, supporting the latest upgrades such as Taproot, and even offering you a way to run your own Bitcoin node. Meanwhile, Ledger Live is still evolving to support more asset-types and networks all the time. 

Finally, Ledger wallets also offer you true ownership over your assets. Since you (and only you) control your private keys, you retain custody over your accounts, and therefore your assets. This is in contrast to centralized exchanges, which only allow you to use an account rather than own it. In the name of trustlessness and accessibility, Ledger devices also use the BIP-39 standard, meaning that with your secret recovery phrase, you can restore your Bitcoin wallet on any other platform—not just a Ledger device.

Whatever you want to do on the Bitcoin network, Ledger devices offer a secure way to transact—without asking you to compromise your control.

How to Create a Bitcoin Wallet

To set up a Bitcoin wallet on Ledger, you need to begin by downloading and installing Ledger Live, if you haven’t already. Once you have completed this step, open Ledger Live, connect your Ledger device to ‘My Ledger’, and make sure that your device is running the latest OS version.

Now you’re ready to get started. So, to create a Bitcoin wallet on a Ledger device, follow these steps:

1. Open Ledger Live and navigate to Accounts
2. Click add an account
3. Use the drop-down arrow or search for the Bitcoin (BTC) app.
4. Connect and unlock your Ledger device and install your app
5. Navigate to your newly installed Bitcoin app. At this point Ledger Live will synchronize with the blockchain 
6. Click ‘add new account’ to install a new Bitcoin account on your Ledger device
7. Click done, and your Bitcoin account should be installed.

How To Use a Bitcoin Wallet

Again, using your wallet all depends on what you want to use it for. So let’s explore some of those functions:

Storing Bitcoin in a Wallet

Bitcoin is not actually stored in your wallet. It’s actually stored on the blockchain. The wallet simply stores the private keys that grant the owner access to your accounts. So, in order to store some BTC in your wallet, all you have to do is buy Bitcoin and send it over to your new wallet—all while retaining access to those private keys.

Sending & Receiving Bitcoin with a Wallet

Before you send or receive Bitcoin, you’ll need to have a Bitcoin account. So, if you don’t have one already, make sure you create a Bitcoin wallet first. Now you have a Bitcoin wallet, let’s go into how you can use it to send and receive Bitcoin. Let’s dive in:

Receiving Bitcoin in Ledger Live

Often, a crypto novice’s first cryptocurrency is gifted to them. If your friend wants to send you crypto, it’s probably best you learn how to receive it. Luckily, receiving BTC directly to your Ledger device is easy. All you need to do is provide the sender your Bitcoin address. To make sure you do that correctly, follow these steps:

1. Navigate to the Receive section in Ledger Live on the left-hand side of the menu.
2. Choose the account to credit and press continue. If you only have one Bitcoin account, you won’t get this choice.
3. Connect and unlock your Ledger device. Then open the crypto asset app as instructed and click Continue.
4. Read the on-screen instructions: click on Verify to display an address on your device and verify that the address shown on your screen is the same as the address shown in Ledger Live.
5. Copy and send the address to the sender of the transaction. Then verify with the sender of the transaction that the address received matches the one shown on your device.

Sending your friend this verified address guarantees that when they send you Bitcoin you receive it—so make sure you verify that address several times!

Sending Bitcoin in Ledger Live

To send Bitcoin, you must already have some Bitcoin, which means you likely already have the Bitcoin app installed. If that’s not the case for you, you can first install the Bitcoin app on your device and then buy Bitcoin using an on-ramp provider via Ledger Live. Now you have your Bitcoin app and some BTC, let’s explore the steps to send Bitcoin in Ledger Live.

1. Choose the ‘Send’ button either on the left panel or at the top of your account page
2. Enter the recipient address and click continue. Make sure that you always double-check addresses
3. Enter the amount that you want to send. 
4. Choose the network fees front he drop-down list and click ‘Continue’
5. Verify the transaction summary before clicking ‘Continue’ once again
6. Unlock and connect your Ledger device
7. Open the app as instructed, click ‘Continue’ and carefully verify all transaction details on your device by pressing the right or left button to view all transaction details.
8. Press both buttons to Accept if everything is correct or Reject to cancel the transaction.
9. If you click accept, your wallet will sign the transaction and send it to the network for confirmation. Choose- By clicking on View details you may track the transaction until it is confirmed.

Bitcoin Wallets: Understanding them is key

As you can see, there are so many different kinds of Bitcoin wallets, from custodial and non-custodial, to hot and cold wallet, and more. Each has their advantages and disadvantages, but whichever you choose, the security of that crypto wallet is paramount.

Whether you need to store, send or receive Bitcoin—or even manage more complicated assets —the best option is to choose a secure wallet. 

So, how will you start your Bitcoin journey? Get yourself a Ledger device and dive into the Bitcoin ecosystem. With Ledger, you have the secure ecosystem, a whole host of apps and services, and the security model to give yourself the confidence to access them. 

And most importantly, Ledger Bitcoin wallets offer you custody and ownership of your assets. Because if not self-custody, then why crypto?

Frequently Asked Questions About Bitcoin Wallets

What is Bitcoin?

Bitcoin is a decentralized digital currency that operates on a peer-to-peer network, enabling secure and transparent transactions without the need for intermediaries like banks. It uses blockchain technology to record and verify transactions. Bitcoin has a limited supply of 21 million coins, which contributes to its value and scarcity.

What are the features of Bitcoin?

Bitcoin has several key features that distinguish it in the world of digital finance. Firstly, it functions as digital gold, providing a reliable store of value much like traditional precious metals. Secondly, its decentralized nature enables peer-to-peer transfers of value, allowing individuals to transact directly without the involvement of intermediaries like banks. Perhaps one of its most distinctive features is true ownership, where users have self-custody of their assets. 

How Much Does a Bitcoin Wallet Cost?

The cost of a wallet all depends on the wallet itself. Software wallets are usually free, but come with security risks. Whereas hardware wallets come with a price, they do offer increased security.

What’s the most secure Bitcoin wallet?

Hardware wallets are the most secure Bitcoin wallets as they protect your private keys much more securely than any other type of wallet. Ledger is a great option as its chip is tamper proof. Moreover, Ledger had never been hacked. 

How to set up a Bitcoin wallet?

To set up a Bitcoin wallet, you can buy a Ledger and install the Bitcoin app, following the steps listed above. 

Why Use a Bitcoin Wallet

A Bitcoin wallet is your primary way to manage, send, and receive your Bitcoin. While software wallets can do this job, hardware wallets significantly improve security by reducing the risk of your Bitcoin being stolen.

Do I need a Bitcoin wallet?

Your Bitcoin is only as safe as your wallet. So, while you can store your Bitcoin on an exchange, it is not advised to do so.