Are more signatures superior? The 101 on crypto multi-signature wallets

Self-custody crypto wallets give investors direct control over their digital assets. With a crucial passcode called a private key, users can authorize transactions and manage their crypto funds without intermediaries. While self-custodial wallets eliminate counterparty risks like mismanagement and data manipulation, they also introduce new security concerns. A single breach exposing a private key can put an entire crypto portfolio at risk.

To make unauthorized access more difficult, some crypto wallets distribute control. Multi-signature wallets require multiple approvals before a transaction can be completed, making it significantly harder for bad actors to compromise funds. Here’s how multi-sig wallets work and why they provide stronger security for crypto investors.

What is a multi-sig wallet?

Multi-sig wallets function like traditional crypto wallets for storing and sending digital assets but use multiple private keys instead of just one. A private key grants users exclusive access to the cryptocurrencies in a wallet, allowing them to authorize transactions with a cryptographically verified signature.

While multi-sig wallets operate similarly to standard wallets, they require multiple signatures to approve transfers. By distributing signing authority across multiple parties or devices, multi-sig wallets enhance security and reduce the risk of unauthorized access.

Traditional vs. multi-sig wallets

The key difference between traditional and multi-sig wallets is that the former uses a single private key, while the latter requires two or more. Because of this, standard crypto wallets are often called "single-key" wallets, as they rely on one private key to access funds and authorize transactions. While this simplicity makes traditional wallets easy to use, it also increases risk – if a thief obtains the private key, they can steal the funds. Also, if a user loses their private key, recovering their digital assets is nearly impossible.

Multi-sig wallets, on the other hand, require multiple approvals from the private keys generated during setup to complete a transaction. This structure makes unauthorized access significantly more difficult, as hackers would need access to multiple private keys. Multi-sig wallets also offer a better chance of recovery if one key is lost, depending on the wallet’s parameters. These added security benefits make multi-sig wallets a popular choice for security-conscious investors and groups managing crypto holdings.

How does a multi-signature wallet work? How to create a multi-sig wallet 

The defining feature of multi-sig wallets is that they generate multiple private keys during setup. These keys are distributed across different devices, entities, or individuals who share control of the wallet. Multi-sig wallets also use a rule-based signing mechanism that requires a predefined number of signatures to authorize a transaction.

For example, in a "2-of-3" multi-sig wallet, three private keys exist, but at least two must approve a transaction before it is processed. When a user initiates a transaction, the system waits for the required signatures before broadcasting it to the blockchain. This multi-signature setup eliminates single points of failure, making it significantly harder for hackers to compromise funds compared to single-key wallets.

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Types of multi-signature wallets

All multi-sig wallets generate multiple private keys, but they vary in the total number of keys and the number of signatures required to approve transactions. While increasing the number of keys and signatures can enhance security, it’s not always the best option for every use case.

• 1-of-2 signature wallet: This setup generates two private keys but requires only one to authorize a transaction. While it functions similarly to a single-key wallet, it provides an extra backup if one key is lost. This makes 1-of-2 wallets a practical choice for users who want added security without the inconvenience of multiple signatures for every transaction.
• 2-of-3 signature wallet: A 2-of-3 wallet generates three private keys but requires two to approve a transaction. This balance between security and usability makes it a popular option for both individual traders and groups.
• 3-of-5 signature wallet: In a 3-of-5 setup, five private keys exist, but only three are needed to authorize a transaction. While 3-of-5 wallets are commonly used by businesses and decentralized protocols, they are less practical for solo investors due to their added complexity.

Advantages of using multi-sig wallets

Multi-sig wallets don’t have the simplest interface, but investors don’t seek them out for UI/UX. Instead, people turn to multi-sig wallets for their strong security features. The additional keys and higher signature requirements provide individuals or groups with greater recovery options and stronger protection against unauthorized access.

• Increases trust within teams: Multi-sig wallets help groups manage crypto treasuries without relying on a single authority. Since different members hold separate keys, transactions require cooperation, reducing the risk of internal theft or unilateral control.
• Enhanced security against hackers: The use of multiple keys and signatures lowers the risk of unauthorized access. Even if a hacker obtains one key, they cannot access funds without the required approvals.
• Loss prevention: Losing one private key is less critical in a multi-sig wallet. While safeguarding keys is still essential, multi-sig wallets allow users to recover access as long as they meet the required signature threshold. For example, in a 2-of-3 setup, two remaining keys can still authorize transactions even if one is lost.

When should you use a multi-sig wallet?

There’s no definitive rule for when to use a multi-sig wallet versus a single-key solution. Instead, individuals and institutions turn to multi-sig wallets when they need enhanced security and shared control. This makes them particularly useful for group-governed funds, such as treasuries for decentralized autonomous organizations (DAOs) and corporations. Distributing private keys in these settings increases trust and transparency, reducing the risk of theft, fraud, or loss.

Multi-sig hardware wallets also offer benefits at a personal level, especially for individuals with significant crypto holdings. A 1-of-2 setup provides an extra layer of security by allowing a second key as a backup in case one is lost. Some investors opt for 2-of-3 wallets for even greater protection of long-term holdings. While 2-of-3 multi-sig wallets may not be the most convenient for frequent transactions, they are well-suited for users prioritizing security over ease of access.

Lastly, multi-sig wallets can be used in trustless escrow transactions for peer-to-peer (P2P) trading or contractual agreements. In these cases, a neutral third party often serves as a co-signer in a 2-of-3 setup, ensuring that neither party can unilaterally move funds without mutual consent. This built-in structure makes multi-sig wallets an effective tool for preventing fraud in transactions requiring shared trust. 

Ready to level up your security with multi-sig?

Whether you prefer hardware, software, or multi-sig wallets, CoinTracker can monitor your crypto transfer activity. After linking your wallet addresses and exchange APIs to CoinTracker's Portfolio Tracker, you'll get a read on your transaction history. CoinTracker can also import all of this data into compliant tax forms like Schedule D and Form 8949 for effortless IRS reporting. 

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Disclaimer: This post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional.