What Is a DeFi Wallet and How To Choose the Right One

After the surge in popularity of decentralized finance (DeFi) in 2020, it has onboarded over 40 million users in total according to Dune Analytics. People use DeFi for many reasons. Some want to buy new cryptocurrencies early. Others want to earn passive income by staking rewards. And some want to lend or borrow money through DeFi.

DeFi wallets make all of this possible. They are essential web3 infrastructure that, when used correctly, give you direct, safe and private access to decentralized applications (Dapps), without the need to rely on intermediaries.

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What Is a DeFi Wallet?

DeFi wallets are non-custodial software applications that provide a gateway to the decentralized finance world, allowing users to store, buy and sell cryptocurrencies and non-fungible tokens (NFTs). Users can also earn passive income by staking or lending crypto on DeFi protocols, like Aave or UniSwap, or borrow funds by locking their assets in a smart contract as collateral.

This type of self-custodial wallet is set up on a phone or computer, either as a standalone application or as a digital interface for a hardware wallet. It generates a private key and backup seed phrase (12 to 24 sequential words generated from a mnemonic algorithm that uses the private key to create a list of words) which you need to store in a safe and protected place that only you know.

If you don’t know what a private key is, stop right now and read this article first.

You will often hear the words self-custodial, non-custodial or private wallet in both Web3 and DeFi. This simply means that your wallet’s sensitive information is encrypted and not stored on a centralized Web2 database such as Google or Amazon, or worse, your bank’s, but rather on one that is supported by thousands of server nodes around the world that the users of that blockchain host.

This makes it the complete opposite of a centralized wallet, which is controlled by a third party such as a crypto exchange or custodial service. As we saw in 2022 with a slew of crypto company bankruptcies and 2008’s banking crisis (which led to Bitcoin’s creation), trusting others to manage your money can cost you dearly.

Of course, DeFi wallets come with their own risks, which we saw with the recent Atomic Wallet exploit and March’s Euler hack. As the industry is still relatively new, it's rife with bad actors. Over $650 million were stolen in the first half of 2023 via scams and hacks according to a Beosin report, and this still pales in comparison to last year. Therefore, make sure you know DeFi’s do’s and don’ts and choose your wallet wisely.

Types of DeFi Wallets

DeFi wallets can be divided into software (AKA online or hot) wallets or hardware wallets (AKA offline or cold).

Software wallets: The vast majority of DeFi users get started by downloading a free mobile app or browser extension (the most popular are MetaMask and TrustWallet) and connecting to a decentralized application (Dapp) by scanning a QR code with their phone or authorizing a popup message on their browser, such as Chrome or Firefox. However, your wallet is connected to the internet, and, therefore, its security is only as good as that of the device it’s hosted on.

Hardware wallets: For users who require more security, a hardware wallet - like Ledger or Trezor - that offers the safety of cold storage may be the best option. Learn more about hardware wallets here.

How Do DeFi Wallets Work?

DeFi is a crucial part of Web3, the growing decentralized internet, and therefore DeFi wallets are interchangeably called Web3 wallets. These wallets replace traditional log-in screens, allowing users to sign into decentralized platforms without relying on centralized entities like Facebook or Google.

Most DeFi wallets are also interoperable and support different blockchains. For example, the world’s most popular Web3 wallet, MetaMask, allows you to switch between any EVM-compatible blockchain like Ethereum, its army of layer-2 chains like Polygon, Arbitrum, and Linea, rival layer-1 networks like BNB Chain, Avalanche and many more.

If you lose your phone or hardware wallet, you’ll need your recovery seed phrase to restore your funds on a new device. Therefore, make sure you keep it completely safe and away from prying eyes.

Important: In order to perform any transaction with your DeFi wallet, you’ll need to fund your wallet first with some of its native cryptocurrency (like ETH for Ethereum and its layer-2 scaling chains and SOL for Phantom). This is called gas, which will be used as a fee to pay miners or validators for their services which keeps the decentralized network up and running.

Benefits of Using a DeFi Wallet

DeFi wallets unlock a decentralized financial system and put you in control of your digital assets. The key benefits include:

Here is an introductory line and bullet point list of DeFi wallet benefits:

DeFi wallets unlock a decentralized financial system and put you in control of your digital assets. The key benefits include:

Self-custody: You fully control your assets and private keys, not any third party like an exchange or bank. This avoids account freezes or clawbacks.
Enhanced security: Funds kept in a non-custodial wallet are much harder for hackers to steal than money stored on exchanges.
Access to Dapps: DeFi wallets let you plug into the newest Dapps for lending, trading, earning yield and more.
Early altcoin exposure: DeFi platforms allow early access to most crypto tokens and projects before they become mainstream.
Interoperability: Leading DeFi wallets support the transfer of assets between different blockchains like Ethereum, BNB Chain, Avalanche etc.
Improved user experience: Features like in-wallet swaps, NFT collections, multi-chain support and Dapp browsers create a smooth on-ramp to Web3.

Checklist: How To Choose the Right DeFi Wallet

Here are a few key things to consider when deciding on the right DeFi wallet.

Self-custody: Your DeFi wallet should be non-custodial (not managed by a third party) and have a private key and/or recovery seed that only you know and can access.
Security: You should always set up your DeFi wallet by yourself. Make sure your wallet of choice is protected by 2FA authentication. A good mobile DeFi wallet should have an integrated web3 browser and be able to screen Dapp transactions to flag potential threats.
Compatibility and Interoperability: Choose a wallet with a solid track record that supports the chain you want to interact with, e.g. Phantom wallet for the Solana ecosystem and Kepler for Cosmos’s interoperable chains. If it can connect to more chains, such as TrustWallet or MetaMask, even better, as it’ll allow you to transfer assets across blockchains with greater ease.
Team: Is there a reputable team behind your DeFi wallet and is their code open-source for the sake of transparency and safety? MetaMask was created by Web3 giant Consensys, while TrustWallet is backed by Binance.
Privacy: A good DeFi wallet should protect your anonymity and not require any personal information, so you don’t become a phishing or real-world target if its database is hacked
Features: Your DeFi wallet should be easy to understand and navigate and feature-rich, with built-in support for the industry’s best Dapps and protocols. If you’re a digital art collector, make sure it has convenient NFT visualizations and collection data.

Risks of Using a DeFi Wallet

While DeFi wallets provide new opportunities, they also come with risks:

Scams: The DeFi space is rife with scams and phishing attacks trying to steal keys and funds. Avoid suspicious sites, links, and transactions.

Hacks: Software wallets connected to the internet can sometimes be compromised by exploits. Use wallets with robust security features.

Private key loss: Losing the private key to your wallet means losing access to your funds permanently. Backup and secure keys properly.

Malicious apps: Only download wallets from official stores. Avoid third-party app stores that may contain malware.

Smart contract risks: DeFi projects can have vulnerabilities in their code leading to exploits. Research before investing.

Custodial risks: Some wallets use third-party custodians, contradicting DeFi's ethos. Opt for non-custodial wallets.

User errors: Being your own bank means responsibility for avoiding mistakes. Take time to learn DeFi wallet best practices.

While DeFi unlocks financial freedom, it requires vigilance. Follow security protocols and utilize trustworthy wallets to minimize risk.

How To Secure Your DeFi Wallet

DeFi allows self-custody of assets but vigilance is mandatory. Follow these best practices:

Strong passwords: Use long, complex passwords that would be difficult for hackers to crack. Consider using a password manager.
Two-factor authentication: Enable 2FA on your wallet to add an extra layer of account security. This requires a one-time code along with your password to log in.
Private key protection: Your wallet's private keys control access to your funds. Make sure to store them somewhere very secure like a hardware wallet or offline away from any internet access.
Update software: Always keep your wallet software updated to the latest version to get security patches and prevent potential exploits.
Avoid phishing: Never input your private key or seed phrase on any unknown site that could be used to steal your assets. Double-check URLs for accuracy.
Transaction screening: Use a wallet that lets you screen transactions to spot any dubious activity like outgoing transfers you didn't authorize.
Limited funds: Only keep a portion of your crypto holdings in hot wallets connected to the internet. The rest should be in cold storage.
New device: When migrating to a new phone or computer, make sure to fully wipe your old device after transferring wallet access.

Conclusion

A DeFi wallet gives you access to the crypto world’s assets and its latest cutting-edge innovations before they go mainstream, while protecting your privacy and staying in full control, which are core tenets of crypto culture.

Of course, there are different risks to stay on top of such as phishing, rugpulls, and blind signing, and these threats will continue to evolve alongside the DeFi sector. Remember that in crypto, the buck stops and starts with you, as it should.

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What Is a DeFi Wallet and How To Choose the Right One

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