DeFi Wallet — What It Is And How It Works
DeFi wallets are the gateway to decentralized finance. They are essential tools to access DeFi platforms directly, while maintaining your privacy and avoiding intermediaries.
In this article we will go over the basics of DeFi wallets, how they work, and how they differ from centralized wallets.
What Is a DeFi Wallet?
In a nutshell, crypto DeFi wallets are primarily intended to be used as a way to store cryptocurrencies.
It is the same principle as the physical wallets we are used to, except that you can use it to store your digital assets. Notably, DeFi wallets have a higher level of security than physical wallets. In fact, they can only be accessed with a password as well as a key phrase — or seed phrase, usually made up of 12 random words, that helps you to recover access to your wallet.
However, the DeFi space is far more than just a place where you can buy and sell financial assets, it’s also a marketplace where you can find a variety of products and services. There is even the opportunity to build decentralized applications and crypto assets. The decentralized crypto wallets serve as the gateway to a whole decentralized ecosystem. By utilizing these wallets, you can have access to this innovative financial and economic system. DeFi wallets are the tools that enables a platform to recognize you even if it doesn’t know any of your personal details.
Simply put, a DeFi wallet allows you to swap assets; earn from lending, staking, farming services; check your NFTs (non-fungible tokens) or connect to platforms to mint and buy them. In the absence of tools that allow you to prove that you own your assets when you access one of these platforms, you would not be able to prove your rights over them.
To recap, these are the main functions and purposes of a DeFi wallet:
- With these tools, you can work in a secure environment: the structure of DeFi is based on smart contracts and decentralization, so it’s harder for hackers to attack it — since it’s harder to attack a distributed system than a system with a central database. Nevertheless, attacks are still possible and it’s up to you to use all the measures to prevent them — for instance, you should never keep a copy of your keys or seed phrases on your devices, you should always keep them in a safe place offline, like a piece of paper.
- Anonymity allows inclusion — no matter your credit score and financial history, anyone can use DeFi services via DeFi wallets, as long as there is an internet connection and enough funds to cover transaction fees.
- DeFi wallets allow you to perform countless operations: not only transactions and the use of financial products, but also to access decentralized applications and to build your applications and create new crypto tokens. For this reason they are defined as “DeFi gateways”: you should think of them as substitutes for the most common login or signup pages you find when you use more traditional websites.
- They allow you to make peer-to-peer transactions and use DeFi financial services in full anonymity.
DeFi wallets serve as the perfect compromise between proof of ownership and anonymity: when you access any DeFi platform with your wallet, you are nothing more than a string of numbers and letters, thanks to the unique address of your wallet — or wallet account, if you have many accounts on the same wallet. Whenever you use your password or seed phrase to access your wallet, you are confirming that you are the owner, and the sole person with the right to access those assets and make transactions.
As a result, you must pay attention to your keys and store them in a secure location. As there are no third parties that manage your wallet, if you lose your keys you will not be able to retrieve your blockchain-based assets.
Security Measures
DeFi wallets typically take some measures to make sure that you fully understand the importance of the keys associated with the wallet. The process goes as follows:
- Choose a reliable DeFi wallet provider which typically offers you the option of downloading some software or web extensions.
- You create a new wallet: As soon as you do this, the service provider will give you the seed phrase. Then, you have to write them down: now, you can check if you wrote them correctly by completing a sort of test. When you realize that you have made a mistake, you can usually go back and re-read the phrase. As soon as you have made sure that everything works as it should, you can confirm the creation of a new wallet. The reasons this phrase is essential are due to the fact that it is exactly what you must have to recover your wallet when, for example, you lose or change the device where you installed the application.
- Typically, the service provider will then ask you to choose a password, which will allow you to easily access your wallet without having to enter the seed phrase.
It is this whole system that allows users to utilize the DeFi platforms without revealing any personal information or relying on any third party.
However, there are different types of wallets available in the crypto space.
Differences Between CeFi and DeFi wallets
You can find both centralized and DeFi crypto wallets in the crypto space. Wallets fall into these two broad categories, and analyzing them will help you better understand the benefits of DeFi wallets, as well as some disadvantages you should know:
- Decentralized cryptocurrency wallets are non-custodial, or user-custodial: this means that you are the only responsible for them. Your wallet isn’t managed by anyone else, and passwords and seed phrases are yours. On the other hand, centralized wallets are custodial, meaning that the providers control your passwords and give you only a kind of interface you can use to make transactions and see the corresponding public addresses.
So, while a key benefit of DeFi wallets is full control over your assets, you still need to pay attention to your passwords because no one can help you to recover your crypto assets if you lose your keys. - Wallets for DeFi need a different structure in order to allow users to benefit from a space that avoids intermediaries. So, each transaction is on-chain and fees are needed to finalize them. CeFi exchanges require you to pay fees too, and these usually also include the fees related to the services provided by the centralized exchange.
- As we said, when you use centralized wallets the provider knows your passwords, and since any crypto wallet needs them to confirm transactions, what providers do is manage your activity. Working like more traditional financial institutions, the procedure is similar to what happens with traditional banks, where this intermediary has the final say on your account. This is also the reason why they need to be compliant with regulations related to the financial space, though they need to know who you are: before using any centralized exchange or wallet, you’ll need to complete KYC procedures to verify your identity. On the contrary, transactions with DeFi wallets occur on a peer-to-peer basis and you won’t need to provide your personal details to use them — that is, DeFi wallets allow you to use them in full anonymity.
- Typically, CeFi wallets are connected to CeFi exchanges; this enables you to transact both in fiat and cryptocurrencies. A DeFi wallet, on the other hand, only allows you to work with cryptos.
Hot Wallets vs Cold Wallets
There are other categories that can be used to distinguish different crypto wallets: hot and cold wallets.
These terms simply describe two different types of storage for your cryptos: cold storage is for all those wallets that work offline; hot storage is for those wallets that are used online.
Usually, cold wallets are perceived as more secure — since they work offline — and come in the form of hardware wallets, but hot wallets allow you to access different DeFi platforms more easily and from different devices.
Among popular hot wallets we can find Metamask, WalletConnect and Trust, while popular cold wallets are Trezor and Ledger.
What You Need to Know When Creating a DeFi Wallet
In general, DeFi wallets are harder to use when compared to centralized wallets. As we mentioned, when you use a centralized wallet or exchange what you get is an intuitive interface that allows you to just confirm the details of your transactions.
But DeFi wallets are different and usually need a deeper knowledge of the crypto space.
First off, you need to select the right wallet according to the blockchain you want to use: in fact, even if many wallets allow interoperability, a DeFi wallet can’t be used on any blockchain or for any DeFi platform.
Once you choose the right wallet — or wallets, according to your needs — you’ll need to get the corresponding software — usually for hot storage — or hardware — generally for cold storage.
After this step, you’ll need to set up your wallet. You’ll need to write down the seed phrase that the wallet will show you — you’ll need it to recover your wallet if needed, so make sure to store it offline and in a safe place — and usually you’ll need to choose a password to access your DeFi wallet more easily.
Once your wallet is ready, you’ll be able to connect it to the platform you want to use, to make transactions, to access decentralized applications. Just click “Connect Wallet” and sign the request for connection.
Most DEXs will show which wallets are supported under the “Connect Wallet” option. For example, KyberSwap supports Metamask, Coin98, WalletConnect, Coinbase Wallet, Ledger — and you can connect them either by clicking on “connect wallet” or even by scanning the QR code provided, to make the wallet even more readily accessible.
As we mentioned, blockchain compatibility is a key point, also from an economic perspective: remember that you’ll need to pay fees to complete transactions, and it might be more convenient for you to use a less expensive network if you can choose.
Sometimes, you won’t be able to choose: for example, if you want to play on Axie Infinity you’ll be required to use Ronin.
Moreover, there are already solutions for all those who are afraid to lose their keys: Argent found a solution for these users and gave them the opportunity to “nominate guardians” that can help them to recover access to crypto funds.
There are a lot of DeFi wallets, so most users end up using more than one. Thankfully, they’re free and not too hard to set up.
Final Thoughts
DeFi wallets are what you need to access the decentralized crypto space. They allow you to prove ownership over your assets while benefiting from anonymity, and that’s why they perfectly fit the needs and purposes of DeFi.
If you are interested in decentralized finance, follow our How To DeFi 101 series to get all the info you need.
