How do you save your keys to your crypto?
a 12-word phrase can secure your coins
Cryptocurrency is now a hotly debated topic. But what about the underlying technologies? In this article we will discuss the different ways of owning crypto, and why different ways of holding it work better for different audiences.
Exchanges like Coinbase and Binance US act much like brokers for stocks. They accept cash from clients in exchange for securities [or property] minus transaction fees, and then hold the securities on behalf of the client. So the same way that a Schwab client doesn’t hold the original stock certificates when they buy Apple, a Coinbase client doesn’t hold the keys to Bitcoin that they buy there. The client still has the ability to buy, hold, and sell the security—as well as collect any dividends. While cryptos don’t have dividends, some offer “staking rewards,” and Coinbase pays these out to the client the same way Schwab pays out Apple dividends to their clients.
But what if you want to hold the keys (the crypto equivalent to an old-school stock certificate) to your Bitcoin (or Ethereum, etc.)? As the name implies, cryptos use cryptographic keys to store data—but how does the average user save the data for their wallet? It can all be stored in the form of a 12-word “seed” phrase. Here is an example:
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When a user starts up with a new wallet app, they are given a phrase like that one to save. Entering that set of words into the same app, in order, on a different device allows the user to get access to all the coins previously saved in the wallet. Of course, anyone who has access to that phrase can access the same coins—so these phrases should be guarded carefully. The public and private keys are all generated using those phrases, and some wallets support multiple coins being saved all with the same phrase.
So for many crypto investors, allowing Coinbase to watch over their coins offers the security afforded by traditional financial accounts—Coinbase keeps track of the underlying keys, and requires a login+password plus 2-factor authentication for security. Now some people will claim “not your keys, not your coins” and that really comes down to a philosophical debate about ownership and control.
If you want direct control over your crypto, you can send your Bitcoin or Ethereum from Coinbase to an address at a self-hosted wallet that you set up (popular choices right now include Electrum for Bitcoin on the desktop, the MetaMask desktop browser plug-in for Ethereum and tokens, and Trust Wallet for multiple coins on mobile). Always be careful to triple-check the address, and always send to an address for the same type of crypto you are sending (there is no undo):
So as long as you triple-check the address and protocol when sending, why wouldn’t you want to hold your own keys? Well, if you are investing in crypto and plan to sell in the medium term, you can avoid transaction fees by keeping your coins on an exchange. Each time crypto is sent to a different address, the network charges “mining” or transaction fees as the cost of writing the transaction to the blockchain. So to send coins back and forth can be expensive, depending on the current rate of congestion in the network. It’s worth factoring in the current fees.
Comparing holding on an exchange and holding in a wallet involves weighing different risks. Like keeping your stock certificates (or cash or precious metals) in a safe, holding in a local wallet leaves one vulnerable to theft or loss of the assets (although storing seed phrases can be done more inconspicuously and redundantly than storing physical goods). On the other hand holding on an exchange exposes the user to more systematic risks (e.g. if the exchange were to collapse or be seized by regulators). So both have vulnerabilities in terms of security and ecosystem and it’s always worth checking into any exchange or wallet that you think about transacting with.
The idea of holding one’s data at the root level and being responsible for it is, indeed, quite confounding to many people in today’s cloud-based society. But while it’s not for everyone, the ability to secure verifiable assets with just a short phrase is a demonstration of a very powerful new financial technology.
Disclosure: Through personal holdings that I control and through investment LLCs in which I am a partner, I buy, hold, and sell stocks, bonds, ETFs, options, NFTs, and cryptocurrencies, not limited to but including some of those discussed in this newsletter. Future events are unpredictable and investments can lose value. Please use extra caution when investing in new sectors like crypto and NFTs.