In the past, I’ve made quite a few Simply
Explained videos on how blockchains and cryptocurrencies work. And there are a few questions that keep coming,
like: how do wallets work? You see, to use a cryptocurrency, you need
a wallet to store your virtual coins. And just like a bank account, it has a unique
address. It looks somewhat like this, depending on
the cryptocurrency. It seems like a completely randomly generated
string of letters and numbers but in reality, there is a bit more going on.
The first thing we need to know is how these
are created. Anyone can create a new wallet by generating
a public and private key pair with a certain algorithm. In the case of Bitcoin or Ethereum that is
via an elliptical curve digital signature algorithm. That’s quite a mouthful, but the take away
here is that the algorithm will spit out a private key and an associated public key. These keys are mathematically linked to each
other. You can take the private key and derive the
public key from it. But you cannot take the public key and turn
into the private one. I made a video about this right here. Now, these two keys serve a different purpose. The public key will become your wallet’s
address, kind of like your bank account number.
And the private key is your way of proving
that you are the owner of the wallet and thus that you can spend the money inside of it. So in summary: public keys can be shared with
everyone while private keys must be kept to yourself. Unless you want other people to decide what
to do with your money. So far so good. But this system has a few interesting side
effects that I want to mention.
For starters, everyone can generate an unlimited
amount of wallets, right on their own computers. It’s only limited by how fast your computer
can generate key pairs. However, nobody will know about the existence
of your wallet until it receives some coins. See, a cryptocurrency only keeps track of
transactions between wallets. It does not have a list of all existing wallets.
So if your newly created wallet has not been
involved in any transaction, it simply doesn’t exist for the outside world. Think of it this way: the blockchain is just
a giant spreadsheet with transactions going from one wallet to another. The blockchain itself doesn’t really care
about if these wallets exist or not. It’s only when you want to spend coins in
a wallet that you have to prove that you’re the owner.
And you can only do that with the private
key that is associated with the address of the wallet. Another side effect is that you can transfer
coins to a wallet address that doesn’t exist. Again a Blockchain doesn’t have a list of
valid addresses, so it cannot check if you’re transferring coins to a valid one. In case you transfer coins to an invalid address
then they're just lost unless someone can generate the private key for that particular
address. Which, right now, isn’t really possible
because of how the algorithm works. Fun fact, this is referred to as “coin burning”
and it’s sometimes done intentionally by cryptocurrency projects that want to reduce
the total supply and therefore increase the value of their coin. Or they do it to get rid of coins that weren’t
distributed during the initial coin offering.
The last cool side effect I want to mention
is that you can create a wallet while being offline, you can then give that address to
someone else and they will be able to transfer coins to it. And later when you get back online, you can
use the private key of that wallet to spend the coins. Cool huh? So if you want to store some coins, in the
safest possible way, you can generate a wallet while being offline, print out your public
and private key, destroy the key on your computer and transfer coins to it. This is called a paper wallet and is the most
radical but super secure way of storing coins. So that was a quick overview of how wallets
work in a cryptocurrency. I hope you liked this video and if you did,
consider subscribing, clicking the bell icon and liking this video. Thank you very much and see you on the next
Simply Explained episode!