Decentralised Finance (DeFi) has been a hot topic for a number of years and continues to draw attention, resources and innovation from all corners of the world. This article aims to give information to those who are interested in delving deeper into accessing this exciting universe of decentralised applications, where bunnies with pancakes on their heads and unicorns come with the territory.
Decentralised wallets, also labelled as DeFi wallets, are the gateways into these vast ecosystems of decentralised applications otherwise known as dApps. As a basis, a wallet is a service that enables a user to store their digital assets and is available under two structures: centralised and decentralised.
Centralised and decentralised wallets
Most of us are familiar with a centralised authority acting as the custodian (or keeper) of our assets, this holds true in the traditional markets (for example, banks) and with digital assets with the most common being centralised exchanges like Coinbase, Binance, Bitstamp and so on. In fact, centralised exchanges are a starting point for many to move funds from fiat to crypto and then make their way into the DeFi ecosystem.
With decentralised wallets, the user self-custodies the funds keeping full ownership, responsibility and control of the funds within. These typically come in the form of software wallets — as browser extension and/or application download — and as a physical hardware device. This article is primarily focused on software wallets which are the most commonly used wallet to connect to dApps and I discuss how hardware wallets can be used with software wallets to exponentially enhance security.
| Centralised Wallets | Decentralised Wallets | ||
|---|---|---|---|
| Control | Centralised entities have an immense amount of control over a user's account and could perform an action such as locking access to it. Importantly, you do not own your private keys (more on private keys and seed phrases later). | With self-custody comes the complete control over your funds and ownership of your private keys. | |
| Security | Vulnerable to hacks and as we see more money flow into this space, there will be greater motivation for malicious actors to focus on vulnerable points of entry to gain access to users’ funds. Although the risk remains, security procedures are continually evolving and the most trusted exchanges strive to be ahead of the security curve. | Exploits typically occur by gaining access to your password or seed phrase by hacking your computer or through social engineering.Never give anyone your password or seed phrase, and store them offline (preferred) or through a trusted password keeper. To enhance security, use a hardware wallet in conjunction with your software wallet (I’ll explain this further). | |
| Convenience | Should you forget your password, the entity can help you recover it via some form of authentication. | Should you forget your password and misplace your seed phrase, your funds are unrecoverable. | |
| Features | Most users will use a crypto exchange to store their funds (fiat and blockchain assets) which opens up the features we are accustomed to from exchanges such as trading - in the spot and margin markets - across order types. Depending on the exchange, additional features like lending, staking and prediction pools may also be available. | Does not hold fiat but stores blockchain assets which include stablecoins. Although there is constant innovation, the main feature is their ability to connect to dApps, which opens up the true power of DeFi. | |
| Regulations | Entities are becoming increasingly regulated and new laws/regulations will continue to impact their operations and therefore, their users. | There is mention of regulation which is largely focused on the dApps, however, no noteworthy news has been released which would impact users to date on decentralised wallets. | |
| KYC (Know your customer) | Must follow KYC procedures (typically proof of identity and address) to ensure compliance in the jurisdictions they have operations in. | No KYC required. | |
| Examples | Centralised Exchanges: Coinbase, Binance, Bitsamp, Luno | Software wallets Browser Extension: Metamask, Trust Wallet, Liquality App Download: Metamask, Edge, Eidoo, Argent Hardware wallets: Trezor, Ledger, D’CENT |
Passwords and seed phrases / private keys
As mentioned, should you forget your password, there is no entity to interact with in order to recover it. The user needs to store their password and seed phrase preferably offline. A seed phrase (also called a recovery phrase) is your encrypted private key that are typically represented as a string of words that you can input should you forget your password and/or lose access to your wallet. Losing your seed phrase will result in your funds being unrecoverable!
To understand these concepts better, this article by lykke.com does a brilliant job of explaining it by using your home as an analogy.
For optimal security, there is a recommended approach that utilises a hardware wallet to store your private key offline. Many software wallets, for example Metamask — the most widely used decentralised wallet — offer integration with hardware wallets like Trezor and Ledger, ensuring maximal security with the flexibility of transacting on decentralised applications. With this integration, every time the user needs to transact on an application, they will require their connected hardware wallet to approve the transaction, which requires a physical touch sequence on the hardware wallet.
The key takeaway is that decentralised wallets are the gateways into interacting with decentralised applications across the blockchain spectrum. This is where the power really tilts in the favour of users who choose to self custody their funds.
Some applications that are worthy of mention are Aave and Compound, who are in the business of lending/borrowing, as well as Uniswap, Sovryn and Pancakeswap, who are primarily focused as decentralised exchanges (DEXs) — where you can swap between a vast array of crypto currencies and stablecoins.
The examples above are just the tip of the proverbial iceberg[1] as there are a myriad of decentralised applications which span a host of blockchains (blockchains like Ethereum, Binance Smart Chain, RSK and Solana to name a few) and the user can connect to them through their decentralised wallet.
What software wallet is best for me?
After reading this article you may have questions regarding what is the best software wallet for you to use as there are a number of options. Remembering that software wallets cover browser extensions and/or application download. In order to keep the focus, I’ll dedicate a separate post to wallet options as it is heavily dependent on a number of factors, one of which is which blockchain you are looking to interact with.
Where to go from here?
Software wallets have been evolving their value proposition with one example being Liquality, where one can store their favourite digital assets and perform an atomic swap (peer-to-peer cross blockchain exchange of one cryptocurrency for another without trusted third parties). This is powerful as one can exchange a cryptocurrency on one blockchain for example ETH (on the Ethereum blockchain) to a completely different asset for example RBTC (the Bitcoin pegged native currency on the RSK blockchain). This is a fantastic use case for anyone looking to move their funds to a different blockchain so they can then interact with those new and exciting dApps!
This post is not to say that decentralised wallets are better than the centralised equivalents. Both structures can (and do) co-exist and provide access to services in differing ways. The goal of this post is to give insight into the growing DeFi ecosystem which, as of writing, sits at $120 billion dollars in market capitalisation with decentralised wallets being the entry point.
Have you been impressed by any wallets, be it software or hardware?
Leave a comment or reach out to discuss!
Footnotes
[1] Be careful out there. Although the innovation is astonishing, hacks are frequent in this space and not all dApps are considered ‘safe’.
Legal disclaimer: The post above does not constitute financial advice. It is very important to do your own analysis/research before making any investment and base this on your own personal circumstances.
Article originally written and published on Medium by Michael Mendez
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