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Hardware and software wallets - what they are and how to use them

Last updated: March 2023 / 780402 o'block

When you first try to learn about Bitcoin, there's a lot of mention of wallets: hardware wallets, software wallets, app wallets, hot or cold, custodial or not, wallets by different vendors... It's easy to get lost in all this. The good news is that to get started, you only really need to understand the two main kinds of wallets, and two ways of using them.

Two kinds of Bitcoin wallets (that can keep on-chain bitcoin):

  1. Software wallet, which is an app/software that runs on your phone or computer and serves as an interface between you and the Bitcoin network. It handles things like figuring out and displaying your bitcoin balances, managing your Bitcoin addresses, constructing transactions (though not always signing them), and broadcasting them to the network.
  2. Hardware wallets are small physical devices that create and keep safe your seed and private keys and sign transactions.

2 kinds of Bitcoin wallets

Two ways of using Bitcoin wallets:

  1. A software wallet can work on its own.
  2. If you have an amont of bitcoin that's large enough to be meaningful to you and want to store it safely, you should look into using a hardware wallet with your software wallet.

But why would you do that? If we can use a software wallet for everything, why do we need a hardware wallet?

  1. If you are using a software wallet only, it will handle everything including creating your private keys, the user-friendly visual interface with your device(phone or computer) and connecting to the network. That means that your wallet is hot (directly connected to the Internet) and if your device is infected with malware, the wallet could be compromised.

    Using a hot wallet
  2. You can use that exact software wallet as an interface to your hardware wallet. If you are using a software wallet with a hardware wallet, the software wallet handles the visual interface/front end of things, and the hardware wallet handles the private keys. This is called cold strage and it is superior because this way your seed/private keys are never online, and there is significantly less chance they can be hacked, stolen and used to spend your coin.

    Using a hardware wallet

Alright, I like the sound of that cold storage. How does that work?

Let's say you want to spend some bitcoin you have in your wallet. You create your transaction in your interface/software wallet, but because it doesn't know your private keys, the transaction is at that point unsigned. The software wallet passes it on to your hardware wallet, and the hardware wallet signs it and passes it back to the interface so it can broadcast it to the Bitcoin network.

Notice the private keys remain offline, never leaving the hardware wallet - only the signed transaction is passed back to your interface software. It's like using those old-timey letters and wax seals: you write a letter and seal the envelope with your seal so everyone knows it was you who sent it, but you only send the letter and your seal is safely kept to yourself.

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This Orange Note is aimed at complete Bitcoin beginners and, in order to keep things simple, is only about light wallets (meaning it's not dealing with running your own node). Once you've mastered the simple, you may want to learn how to use a node - it's a whole new better way of using the Bitcoin network!

Graphical abstract ?

Graphical abstract: for when you just need a quick overview or reminder - same stuff as above, just all in one image.

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