When you own cryptocurrencies, you store your assets in such a way that only you can access them, you have full control at any time, without counterparty risk. Banks usually keep a fraction of what is on their balance sheets as a reserve due to their business model of providing loans. Put plainly; banks can provide loans while maintaining very few funds on their balance sheet. This system is widely known as fractional reserve banking.
What do banks do with money?
Traditionally, Banks store your currency in an account in your name. The consensus is that you have access and can withdraw your currency at any time. In theory, this might sound correct, but the bank doesn’t necessarily have your money.
Banks usually keep a fraction of what is on their balance sheets as a reserve due to their business model of providing loans. Put plainly; banks can provide loans while maintaining very few funds on their balance sheet. So, this so-called fraction is what they keep as collateral. This system is widely known as fractional reserve banking. On top of this, the bank is the legal owner the moment your funds enter your bank account. Moreover, it is legally able to deny you “your funds”. By converting fiat currency into cryptocurrencies, you can store your assets in such a way. Therefore, only you can access them, you have full control at any time, without counterparty risk.
By becoming your own central bank(er) and taking back responsibility, you are accountable for the security of your (digital) assets. The role previously filled by the trusted third party. However, this time you are responsible, not the banks. So, if you do not take your responsibility seriously, you might just as well lose everything.
How do cryptocurrency wallets work?
Cryptocurrency wallets are software programs that enable us to interface with the network (blockchain) to keep track of our transactions and assets. So, you can compare a cryptocurrency wallet with your bank account, a mailbox or an email address. Moreover, you can interact with each of them if you have the required proof (identity, key or password). Therefore, cryptocurrency wallets work with public and private key pairs.
“In simple terms, you can think of the public and private key pair just like an email account, the address is similar to your username or email address, and the private key is like your password. If you want to send the coins from your wallet to another wallet, you will need your private key. This is exactly like an email account; the email address is a point of reference for users on the email network to send mail to, and the password gives you full access to the privileges of the account-chiefly, the ability to draft and send emails to other accounts.”
Risks of storing crypto on the exchange
Security is a hot topic and a huge issue in the crypto environment. Moreover, it should never be taken lightly. On many centralized exchanges, you are not in control of your private key. Instead, exchanges let you log-in with a username and password combination. So, this implies that you do not truly own your assets, as the exchange “custodians” hold your private keys. Not owning your private keys means that you do not have full control over your funds.
Everyone knows exchanges are subject to attacks from malicious parties. Therefore, they are trying to gain access to the funds of all users and the exchange’s reserves. For example, you sign up with an exchange, create an account protected with a password ( and 2FA) and the exchange gets hacked or otherwise compromised; you might well lose your investments since the hackers now have access to the private keys of registered users of the exchange. Now the exchange functions precisely the same as a regular bank.
“Not your keys, not your Bitcoin!”
–proofofkeys.com
Security and technical complexity
Keep in mind that a safer and more secure wallet adds more layers of technological sophistication. This complexity, in itself, imposes additional risks if you do not know precisely what you are doing. It is a lot easier to run a wallet on your mobile phone or desktop with a simple PIN or password then it is to run dedicated cold storage or multi-signature wallet. People who overextend (cause they aim for higher security) might just as well lose their funds because they underperform on execution and handling of these more complicated systems. Assess what an acceptable level of risk for your specific situation and circumstances is based on your commitment and invested funds.
Which wallet is best for me?
There are a lot of different cryptocurrency wallets available and more diverse and advanced wallets are being launched frequently. Before selecting a wallet, you should think carefully about how you intend to use it. Do you need a wallet for everyday purchases, or do you need a wallet where you can actively trade? Should I also have a dedicated wallet that functions as an offline vault for your long term investments? Are you planning on using a host of cryptocurrencies, or only Bitcoin? Do you require access to your digital wallet from multiple devices or just your mobile phone?
In general, try to reduce potential risks by spreading around your assets if you have a considerable amount invested. When you diversify, you aim to manage your risk by spreading out your funds. You can, of course, expand and diversify both within and among different asset classes. But when it comes to cryptocurrencies, you can take any number of assets with you on a mobile wallet and store the rest safely on (multiple) other locations. For instance, you would have registered at one broker exchange (to convert your fiat to crypto) and at another trading exchange (where you trade crypto to crypto). You might also have a dedicated hardware wallet to store the majority of your assets offline and have a small portion on a wallet on your phone to be able to take with you for easy access and liquidity purposes. Take some time to assess your requirements and only then decide on the most suitable wallet(s) for you.
