What is the difference between a Bitcoin wallet and an exchange?

A Bitcoin wallet is basically a software program in which you store Bitcoin. An exchange allows you to convert “real money” such as US dollars into Bitcoin. Exchanges also offer a wallet, but you don’t necessarily have full control over that wallet.

We do not recommend investing in Bitcoin. But if you’re putting money in Bitcoin – or you’re just interested in how it works – you should know this.

What is a Bitcoin wallet?

So, we mentioned before that a Bitcoin wallet is a software program in which you store Bitcoin. While it is true, it is a drastic oversimplification. Bitcoins are never really “stored” anywhere. To understand what a Bitcoin wallet is, it is important to understand what Bitcoin is and how it works.

RELATED: What Is Bitcoin and How Does It Work?

A Bitcoin wallet actually contains one or more private keys that you can use to sign transactions. These private keys are the mathematical proof that you do indeed own a certain amount of Bitcoin. Think of these private keys as secret codes that allow you to spend that Bitcoin. The blockchain is a record of all these transactions.

These private keys are very important. If someone steals your private keys, say if you have malware running on your computer, they can spend your Bitcoin. For example, they can use your private keys to send your Bitcoin to their own Bitcoin address. Your Bitcoin would then be stored in their wallet and secured by their own private keys, which you would not have access to. Therefore, it is very important to store your Bitcoin wallet and its private keys securely.

Attackers are not the only concern. If you lose the wallet and your private keys, you will also lose access to all your Bitcoin. That’s why it’s important to have backups of your Bitcoin wallet as well, just as you would have backups of all important data.

If Bitcoin was widely used for payments, a Bitcoin wallet is the program you would also use to send and receive Bitcoin for everyday transactions. You may want to store only a small amount of Bitcoin in a wallet you carry with you, for example on your phone, and leave a larger amount of Bitcoin in a more secure location, similar to how you don’t carry your savings with cash in your physical wallet. There are some websites that accept cryptocurrency paymentsHowever, Bitcoin is currently largely used for speculative investing.

In addition to the typical software Bitcoin wallets that you can use on a PC or phone, there are hardware-based Bitcoin wallets such as the TREZOR† You can also use a paper Bitcoin wallet, which has a Bitcoin public address and private key printed on it. This is basically an offline Bitcoin wallet and you can store it in a safe or other secure location without worrying about it being compromised by malware on your PC. Of course, anyone who bought the piece of paper would have the opportunity to spend your Bitcoin.

RELATED: How to accept Bitcoin or cryptocurrency payments on your website

What is a Bitcoin exchange?

A Bitcoin exchange is a website or service that allows you to convert “fiat currency” such as US dollars and euros into Bitcoin. These websites also allow you to convert that Bitcoin back to US dollars or your fiat currency of choice. In other words, exchanges buy and sell Bitcoin at the current market rate.

If no exchanges existed and you wanted to buy Bitcoin with US dollars, you would have to find someone with Bitcoin, agree an exchange rate, pay and then have that Bitcoin sent to your wallet. And to sell Bitcoin, you need to find someone who is willing to buy it from you. Exchanges simplify this process and provide a single place where you can buy or sell Bitcoin at the current market rate using your bank account.

But exchanges also have integrated wallets

Exchanges like Coinbase, which we think is the best choice if you want to buy Bitcoin, provide you with a Bitcoin wallet hosted by that website. Think of this as a kind of web-based Bitcoin wallet.

RELATED: Buying Bitcoin the Easy Way?

So if you go to Coinbase, create an account and buy some Bitcoin, that Bitcoin is not immediately sent to a Bitcoin wallet address you provide. Instead, it is stored in a wallet in your Coinbase account. You can sign up to the Coinbase app or website, view your balance and sell the Bitcoin if you wish. Coinbase allows you to transfer the Bitcoin from the Coinbase exchange to another Bitcoin wallet, if you want, but you have to try your best to do that.

This drastically simplifies the process of buying Bitcoin. You do not need to install and manage Bitcoin wallet program. You don’t need to back up your wallet. You don’t have to worry about losing your Bitcoin if you forget your wallet password or lose all copies of the wallet files. Instead, you just create an account and access your Bitcoin by logging into that account. If you have forgotten your account password, you can go through an account recovery process.

In this situation, the exchange functions as a bank. When you store your Bitcoin with Coinbase, Coinbase will hold and access your Bitcoin for you. But the Bitcoin is under their control, not yours. And while banks in the US and other countries are heavily regulated, it’s important to remember that Bitcoin exchanges are not subject to the same rules.

The exchange manages the wallet’s private keys

Here’s the big concern: When you store your Bitcoin in a wallet operated by an exchange, such as Coinbase, that exchange actually contains the private keys. In other words, it’s a bit like the exchange that stores your Bitcoin in their own wallet and gives you access through an account. You don’t actually have the Bitcoin in your own wallet that you fully control, as you would with a traditional Bitcoin wallet.

You put a lot of trust in the exchange if you store your Bitcoin there. For example, you can lose your Bitcoin if the exchange is hacked, a rogue employee has stolen your private keys or if the owners of the exchange have stolen the money and run away. That’s one of the reasons we recommend Coinbase, a larger company with a decent track record in the US, for smaller exchanges that may not be as reliable.

In fact, the design of web-based Bitcoin wallets that function like banks goes against some of Bitcoin’s original intent. Bitcoin promises a fully decentralized system that allows you to store your own money without trusting anyone else. And you can – if you store it in your own wallet. When you store it on an exchange, you rely on that exchange like you would rely on a bank.

Of course there are tradeoffs. When you rely on an exchange, you have an easier experience. You don’t have to worry about securing, backing up or otherwise managing your own Bitcoin wallet. The exchange’s website will be more secure than many people’s computers.

Should you keep your Bitcoin in a web wallet provided by an exchange, or your own Bitcoin wallet? There isn’t the right answer for everyone, but it’s important to understand the tradeoffs if you own Bitcoin.

Image credit: IhorL/Shutterstock.com.

Leave a Reply

Your email address will not be published.