How Does a Crypto Wallet Work?

In many ways, a crypto wallet is the primary tool for any blockchain user – it’s the thing you need just about every time you want to interact with the world of web3. Naturally, as with most things blockchain, a lot is going on under the hood.

Whether you use a physical hardware wallet or a software wallet on your web2 device, understanding how they handle transactions is imperative. It could make or break the security of your accounts! Crypto wallets are not created equal, and they all handle things a bit differently and have different strengths and weaknesses when it comes to self-custody, security, and more.

So, whether you’re new to the world of crypto or just curious about how these wallets operate, you may want to get your head around how different wallets process transactions. 

From hardware to software wallets, let’s dissect the intricacies of how crypto wallets work, and help you protect your assets effectively.

What Is a Crypto Wallet?

Contrary to what the name may suggest, a crypto wallet does not actually contain any cryptocurrencies – those stay on the blockchain itself. Rather, a crypto wallet acts as the bridge between you and the decentralized world by carrying out two key functions. 

Firstly, crypto wallets store private keys, which grant you access to the digital assets tied to a specific blockchain address. To explain, in its raw form, a private key is a long string of 1s and 0s that would be impractical for people to store and use. Crypto wallets store your private keys you don’t have to.

Of course, the crypto world has greatly evolved from the earliest days of simple Bitcoin transactions. Most notably, the rise of decentralized applications (dApps) and decentralized finance (DeFi) has seen more and more complex crypto transactions and use cases emerging. Thus the second key feature of modern crypto wallets is to act as a user interface, allowing you to conveniently send, receive, and manage your assets, and connect to dApps. 

How Do Crypto Wallets Work?

As mentioned above, crypto wallets store your private keys and act as an interface, allowing you to carry out various blockchain transactions. All of these transactions require you to sign for them using your private keys, which verifies for the nodes on a blockchain that each transaction is authentic.  

As you might already know, most crypto wallets use an HD structure, meaning you can create and manage a near-infinite number of accounts using a single Secret Recovery Phrase (SRP). To clarify, an SRP is a single mnemonic made up of 12-24 English words wallet that you receive when you first generate a new crypto wallet. You can think of the SRP as a master key for all of the private keys for your different wallet accounts. Notably, you can use your SRP to restore all of the accounts attached to it on any wallet interface or device.

Of course, there’s a bit more to it than that. For one thing,  each wallet generates and stores private keys slightly differently, greatly affecting how they operate. Beyond that, crypto wallets don’t just rely on blockchain tech, but on software and hardware too. 

So how does a cryptocurrency wallet process a transaction exactly?

How Does a Crypto Wallet Execute Transactions?

As mentioned above, a crypto wallet stores private keys, allowing the holder to initialize, sign, and then broadcast a blockchain transaction to the network. Here’s a step-by-step process of how a crypto wallet works in practice:

1. You initialize a transaction via the wallet’s interface
2. The interface presents you with the “intent” – a digital proposal with the details of your potential transaction
3. You press confirm on the wallet interface 
4. The wallet uses your private key to sign the transaction
5. The signed transaction is sent to the network

While all cryptocurrency wallets follow this framework, there’s still some variety when it comes to their underlying tech. To understand how let’s look at each type of crypto wallet and how their processes vary.

How Does a Software Wallet Work?

A software wallet is an application that you install on your computer or mobile phone. Software wallets keep your private keys in an encrypted state on their host device and use the device’s screen to present their interface to initiate and confirm transactions. 

Let’s see how the crypto transaction process works with a software wallet:

1. You initialize the transaction from your wallet’s interface
2. The interface provides you with the intent.
   However, this intent is presented to you via the screen of your internet-connected device. This means the display of your transaction details can potentially be tampered with by hackers. In this sense, a software wallet can never offer you absolute certainty about what you are signing. 
3. You press confirm to approve the transaction 
4. The software wallet signs the transaction using the private key stored on the host device.
   In doing so, your software wallet accesses and uses that private key while your host device is connected to the internet. This is a potential threat, as the host device—your laptop or smartphone—is vulnerable to malware and spyware. Yes, if you use these types of wallets a hacker can extract your private keys. Or, they can even tamper with your screen to lure you into accepting a malicious transaction. 
5. The software wallet uses the internet connection of its host device to broadcast the signed transaction.

How Does a Hardware Wallet Work?

A hardware wallet is a physical device that keeps your private keys secured in an offline environment. These wallets physically store your private keys within a chip inside the device. The beauty of using a hardware wallet is the security it provides to your private keys. Signing offline means your private keys remain out of reach of hackers, even as you’re transacting. 

To operate, it needs a connection to a separate device, such as a smartphone or laptop, where you can install its companion software. This is what allows you to send transactions via the internet even though your hardware wallet does not connect to the internet itself. 

To understand the process fully, let’s explore how a hardware wallet processes a transaction:

1. You initialize the transaction from your wallet’s interface, the companion software you have installed on your internet-connected device
2. The interface provides you with the intent.
   This is shown on your internet-connected device’s screen    
3. You confirm the transaction using the interface on your internet-connected device and then authenticate the transaction by physically confirming it on your hardware device.
   This acts as a form of 2FA to guarantee that only someone with physical access to the device can execute a transaction. That means hardware wallets must also employ measures to protect users from thieves and physical hackers.
4. The hardware wallet signs the transaction using the private key stored in its chip
   Your hardware wallet stores your private keys on its computer chip. When you confirm a transaction on the device it can use your private key to sign the transaction. However, it does so offline within the device’s chip, away from an internet connection. This protects them from potential onlookers using spyware on your laptop or smartphone.
5. The hardware device sends the signed transaction to your internet-connected device via Bluetooth or USB-C cable and then broadcasts it to the blockchain.
   An already signed transaction is safe to send through a potentially insecure channel. So from there, your interface can send the transaction to the network’s nodes for validation.

However, it’s important to note that not all chip types offer the same level of security. To clarify, hardware wallet hacks do happen. And often, unaudited chips are to blame. A wallet is only as secure as its security model—more specifically as its embedded software stack and hardware components.

So with that in mind, how do Ledger crypto wallets work?

How Does a Ledger Crypto Wallet Work?

Well, Ledger crypto wallets contain many components and features that set them apart from other devices on the market. Plus Ledger’s battle-tested security model extends much further than its devices too. All pieces of the Ledger ecosystem, from the device’s OS and embedded apps to the companion app Ledger Live, work together to keep your assets safe. And they all contribute to your security throughout each transaction. Let’s first explore how your Ledger wallet stays secure.

PIN code

The only way to unlock a Ledger device and use it to sign transactions is through a PIN code. Plus, only one person will ever know the PIN. The only way to create it is when setting up a new Ledger crypto wallet. Essentially, it guarantees that no one other than the wallet’s owner can execute a transaction. This keeps your wallet safe from thieves who could potentially gain physical access to your crypto wallet device.

Secure Element

Ledger distinguishes itself from other hardware devices through its key security component: the chip. All Ledger cryptocurrency wallets contain a component known as a Secure Element. This high-security computer chip is so safe it’s the same chip you will find in your bank card and biometric passport. This chip is practically tamper-proof and protects against countless hacks. It also runs the embedded apps you install on your device and stores your private keys.

Secure Screen

Ledger crypto wallets also feature a secure screen, a tamper-proof screen isolated from the internet connection. The screen enables you to verify the full details of your transaction instead of trusting the screen of your internet-connected device before physically verifying the transaction using the two buttons on the device. 

Operating system

Ledger has developed a secure OS that ensures all the applications on your device operate separately from one another. This means that there is no single point of failure within the wallet. 

Moreover, it’s Ledger’s secure OS that mandates a physical confirmation for each cryptocurrency transaction. This means nobody can ever transact without your knowledge. Only you can confirm each transaction, and you must do so physically with your device.

Ledger Live: A Secure Companion App

Ledger devices connect to your laptop or smartphone via Ledger Live, a secure companion app. This piece of software is installed on your smartphone or laptop and allows you to initiate transactions and communicate with the blockchain. While your Ledger crypto wallet handles signing transactions offline and keeping your private keys safe, Ledger Live is responsible for granting you access to apps and services. 

It’s also responsible for delivering the latest security updates to your crypto wallet and verifying its authenticity. Every app within Ledger Live comes with a clear signing plugin that allows you to read each transaction in human-readable language—ensuring you don’t sign away your assets without knowing it. Simply, Ledger Live is the perfect companion crypto wallet app for your Ledger device: secure, accessible, and easy to use.

Example of How Ledger Crypto Wallets Work

So now you understand how Ledger wallets are unique, let’s see how these pieces work in practice

1. You initialize the transaction via the Ledger Live App
   Ledger Live is the companion crypto wallet app for Ledger devices that allows you to initialize transactions.  From this single app, you can also access countless blockchain apps and services. You can only initiate transactions if you connect your device securely. The added security feature of a PIN code guarantees that even someone with physical access to your device cannot access your funds.
2. Ledger Live provides you with the intent, which you can then confirm or reject
3. When you confirm the transaction via Ledger Live it will prompt you to approve the action physically on your Ledger device
   At this point, the destination address is also shown on your Ledger’s secure screen. This allows you to double-check that the destination address on your hardware wallet matches your host device. This way, no one can trick you with malware on the latter. To clarify, your Ledger device (including its secure screen) is practically un-hackable, so you can trust the transaction details it shows.
   
   Confirming the transaction physically on the device guarantees that only someone with physical access to your device can confirm a transaction. Only you can unlock your device with the PINcode, so no one can access your funds remotely.
4. The transaction is signed using your private key stored in the secure element.
   The transaction is signed in the Secure Element chip, a completely offline environment. This guarantees that your private keys stay safe from potential onlookers via spyware on your internet-connected device. Plus, the secure element is also tamper-proof, serving as another layer of security against physical hacks.
5. Your Ledger crypto wallet sends the signed transaction to your internet-connected device via Bluetooth or USB-C cable, which then broadcasts it to the blockchain.
   Ledger Live also checks the authenticity of your crypto wallet, meaning that if your device has been tampered with, you will be able to tell. That means you can send transactions from your Ledger crypto wallet to the blockchain with confidence.

Types of Wallets: Cold Wallets vs Hot Wallets

The distinction between hot wallets and cold wallets simply refers to whether a wallet exposes its private keys to the internet or not. A hot wallet uses private keys to sign transactions while connected to the internet. In contrast, a cold wallet keeps private keys in a completely offline environment, even when signing transactions. 

Types of Hot Wallets

Software Wallets

A software wallet is an application that you install on your computer or mobile phone, allowing you to use your device screen as an interface to interact with the blockchain. 

Web Wallets

Web wallets are accessed via browser extensions on computers, making them very user-friendly, though they share the security weaknesses of other internet-connected software wallets. 

Desktop Wallets

A desktop wallet is a software application installed and operated on a desktop computer. 

Mobile Wallets

A mobile wallet is a software application that is installed on a smartphone or tablet. 

Types of Cold Wallets

Hardware Wallets

A hardware wallet is a physical device that stores private keys in a computer chip isolated from your internet-connected device.

Paper Wallets

Paper wallets are one of the earliest and simplest types of cold wallets. They are simply pieces of paper with private and public keys printed on them, usually in the form of a QR code.

Types of Wallets: Custodial vs Non-Custodial Wallets

Custodial Wallets

A custodial wallet is one whose private keys are held and controlled not by the user but by the wallet provider, usually a centralized crypto exchange. Using a custodial wallet means forfeiting ownership of your funds to a centralized custodian. If something happens to that platform—maybe it goes bankrupt or the CEO goes rogue—your crypto may be at risk.

Non-Custodial Wallets

Non-custodial wallets, both software and hardware, require you to store your own private keys. This gives you true ownership of your assets but requires responsibility. Typically non-custodial wallets are only recoverable using a seed phrase, a series of 12-24 words. Without the seed phrase, you lose access to your accounts should you lock yourself out. 

You’re Only as Secure as Your Crypto Wallet

Remember, when it comes to crypto you’re only as safe as the crypto wallet protecting your private keys allows you to be. No matter how you’re interacting with that ecosystem – whether it’s exploring dApps and DeFi, or strictly trading crypto– it’s important to understand what happens each time you hit confirm.

That’s why choosing the right crypto wallet is so important, and why Ledger takes security seriously.

Malicious actors will always be looking for potential vulnerabilities. That’s why Ledger’s security team, the Ledger Donjon, constantly tests the security level of devices; rolling out updates to fix any vulnerabilities and build stronger security measures for the wider ecosystem too. 

In short, Ledger cryptocurrency wallets keep your private keys safe and give you agency over your assets. Meanwhile, the wider Ledger ecosystem gives you the option to buy, swap, stake, and manage your crypto holdings securely. Essentially, Ledger gives you the possibility to be in control of your digital life.

So why wait? Start exploring web3 from the safety of the Ledger Ecosystem, where only YOU control what happens to your crypto.

Frequently Asked Questions about Crypto Wallet

Do I Need a Crypto Wallet?

If you want to buy, sell, or hold crypto, or interact with a blockchain wallet, then you are going to need a crypto wallet. Cryptocurrency wallets provide you with the necessary interface to interact with the blockchain while allowing you to secure your assets.

Why Are Crypto Wallets Important?

Crypto wallets are at the very foundation of blockchain technology, allowing you to conveniently manage and secure your digital assets without the need for a centralized third party. From buying, selling, and holding crypto, to exploring decentralized apps (dApps), crypto wallets are the primary way that individuals interact with the blockchain.

How To Choose a Crypto Wallet?

From hot wallet to cold wallet, each type of crypto wallet comes with its own strengths and weaknesses, with some more suited to certain functions than others. That said, there are certain factors that you should consider when choosing a crypto wallet: how secure it is, whether it offers self-custody, what networks it supports, and cost, among other things.

How To Use a Crypto Wallet?

Once you have set up your crypto wallet and stored your secret recovery phrase, you’ll generally be able to access it via a PIN code or password, depending on your wallet provider. Once signed in, you can now use the wallet to manage your assets.OU control what happens to your crypto.