Your bitcoin isn’t in your wallet

What a bitcoin wallet actually is, and what it isn't

(This article was originally published in the Unchained Blog)

Although it’s one of the most popular terms when discussing Bitcoin storage, “wallet” often gives the wrong idea to newer Bitcoin users. In the two years I’ve spent on the Concierge team at Unchained, helping hundreds of people from all walks of life set up multi-sig security for the first time, I’ve witnessed no other word be responsible for as much confusion as “wallet.”

While learning about Bitcoin, I remember being confused about what a Bitcoin wallet was, and how it worked. It took some time before my lightbulb moment finally happened, and I realized that Bitcoin wallets don’t hold any Bitcoin!

This article is for those who haven’t had their lightbulb moment yet. We’ll explain where your Bitcoin is located, and help you think through terms such as “hardware wallet,” “software wallet,” “hot wallet,” “cold wallet,” “watch-only wallet,” “self-hosted wallet,” and more!

Why “wallet” is confusing, and where your Bitcoin is located

When people think of a wallet, they are naturally going to think of a physical place where money is kept. After all, this has been the definition for many generations. When applying the same idea to a digital economy, people will often think of a digital account existing somewhere, holding their money. However, for a Bitcoin wallet, this perception is inaccurate.

All bitcoin, including yours and everyone else’s, exists on the blockchain. The blockchain is a public ledger, and it doesn’t exist in any one physical location.

Hundreds of thousands of copies of it are stored all around the world, wherever someone runs a Bitcoin node. You can easily run a node yourself, and keep a copy of the blockchain in your home!

All nodes communicate over the internet to stay up to date with the latest transactions, and no one node is more powerful than another, which is what keeps Bitcoin decentralized.

Eventually, all 21 million bitcoins will be on the blockchain. There is no way to remove Bitcoin from the blockchain and store it somewhere else.

When people mention “off-chain” transactions (such as lightning transactions), the bitcoin remains on the blockchain, but the ownership of the bitcoin changes without needing to update the blockchain.

Furthermore, bitcoin doesn’t exist in “accounts” or “wallets” on the blockchain. Bitcoin exists on addresses (there’s some technical nuance here as well, which we’ll ignore for this article).

The blockchain keeps track of which addresses hold bitcoin, and how much. The blockchain does not, however, keep track of who those addresses belong to.

Someone who owns Bitcoin can hold it across many different addresses, and there would be no public connection between those addresses unless subsequent privacy-compromising actions are taken.

What a Bitcoin wallet is

Once you understand that everyone’s bitcoin exists on addresses, and the information is stored on everyone else’s node, you might still be wondering what a “bitcoin wallet” is. Is a wallet the same thing as an address? Many readers will know that the answer is no because a wallet can produce many different addresses for receiving bitcoin.

So, what is a wallet? The best definition for a Bitcoin wallet that I’ve seen is “a collection of Bitcoin addresses controlled by the same keys in the same way.” For example, one extended key can produce a collection of addresses, which would constitute a single-sig wallet.

Or, multiple extended keys could combine to create a collection of addresses, forming a multi-sig wallet. Using the same keys but different quorum sizes or address types will also lead to different wallets.

When someone interacts with a Bitcoin wallet, what they are doing is using software that can calculate the addresses for a particular structure of keys. Typically, that software can connect to a node, so that it can scan the blockchain to determine if any of the addresses have received bitcoin. If they have, you will be able to see your wallet balance and transaction history.

Although it may be counterintuitive, it’s fair to say that Bitcoin wallets do not hold Bitcoin. Instead, bitcoin wallets help people create addresses to receive Bitcoin into a specific key structure. Wallets also help people identify addresses on the blockchain that have already received Bitcoin in a particular key structure.

When people say “I have Bitcoin in my wallet,” what they really mean is “There is some Bitcoin on my wallet’s addresses.” Although the difference between these statements may seem trivial, it’s important for proper education, to help avoid the common mistake of thinking that bitcoin can be held on a server, in a phone, or some other location apart from the blockchain.

“Hardware wallets” are not really wallets

One of the most unfortunate terms to ever catch on within the bitcoin industry is hardware wallet. A hardware wallet is a popular name for a device such as a Trezor, Ledger, or Coldcard, which helps people secure Bitcoin.

However, as previously mentioned, these devices cannot hold Bitcoin inside of them. Even worse, these devices don’t even meet our definition of a wallet, which we just covered! They would be better described as “hardware that helps protect Bitcoin wallets.”

If you’ve used a Trezor, you may be familiar with its companion software, Trezor Suite. If you’ve used a Ledger, you should be familiar with Ledger Live. If you’ve used a Coldcard, you’ve had to choose a software program like Sparrow Wallet.

In each of these cases, it’s the software programs (Trezor Suite, Ledger Live, and Sparrow Wallet) that provide the full functionality of a bitcoin wallet. They possess the ability to connect to an online node, monitor the blockchain for balance activity, and broadcast spending transactions.

The device (Trezor, Ledger, or Coldcard) merely exists to keep a private key secure and offline, which can be used to spend funds out of the wallet.

For this reason, many people have suggested trying to rename these devices as “key managers” or “signing devices.” Unfortunately, such attempts have had little success so far, because the term “hardware wallet” is so deeply entrenched in the industry and culture.

Software wallets and watch-only wallets

A software wallet is a term that’s used more accurately because it generally refers to an actual Bitcoin wallet. However, it often implies a “wallet which is not protected by offline hardware,” also known as a hot wallet.

In this case, the private key that allows for withdrawing funds is stored on the same internet-connected device as the wallet software itself. This is a less secure way to hold Bitcoin.

A watch-only wallet describes a wallet software that does not include a private key on the same machine. Instead, the private key is held elsewhere, such as in an offline device like a Trezor, Ledger, or Coldcard (when the key is protected offline, it can also be described as a cold wallet). Trezor Suite, Ledger Live, and the Unchained platform are examples of watch-only wallets.

However, this “watch-only” terminology can also confuse, because if someone possesses the appropriate private keys, they will certainly be able to spend out of a wallet that is “watch-only.” By the same token, any wallet can become a watch-only wallet permanently, if the private keys get lost or destroyed.

“Self-hosted” wallets and “unhosted” wallets

The term self-hosted wallet was invented by those looking to regulate Bitcoin wallet use, not the Bitcoin community. If you’ve understood this article so far, it should be clear that describing a Bitcoin wallet as “self-hosted” doesn’t make sense.

All Bitcoin is hosted by the blockchain, which in turn is hosted by anyone and everyone running a Bitcoin node. If a regulator or lawmaker wants to ensure that all Bitcoin wallets are hosted by someone else, they’d simply need to run their own Bitcoin node! For similar reasons, the term unhosted wallet (a common alternative term, meant to be synonymous) doesn’t make sense either.

When someone uses one of these terms, what they are usually referring to is a wallet that can be accessed by an individual holding their own private keys. This ability to hold your own keys is what allows Bitcoin to be permissionless to use, rather than requiring approval from a third-party custodian who holds the wallet’s private keys.

by Tom Honzik

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