One of the most attractive aspects of cryptocurrency is that individuals control their own money. Banks or governments can’t own blockchains like Bitcoin or Ethereum. Instead, they’re decentralized networks run by a vast network of independent users.
It’s an incredible system and presents an endless amount of innovative opportunities for the future of finance. However, it comes with its own risks, especially regarding user security.
In particular, how do users keep their cryptocurrency safe? How should individuals store their crypto without a centralized authority to oversee transactions and provide security?
For users who want to store their crypto themselves, they have the choice to use hot or cold wallets. Some people choose to use a combination of the two. Are you wondering about the difference between hot and cold wallets and how to choose the best one for your needs? Read on to learn more.
What is a crypto wallet?
A crypto wallet is used to store, send, and receive cryptocurrency coins and tokens. It functions similarly to a bank account, except it’s more private.
Unlike a bank account where the bank can access your funds, crypto wallets can only be accessed by users who hold the private key.
Crypto wallets have both public and private keys. Public keys function like addresses – this is what you input to deposit funds in another person’s account. A private key is known only to the wallet owner. It shows proof of ownership of the funds inside the wallet and must be entered to make any transactions in or out.
To be more specific, wallets don’t hold coins or tokens in the same way a physical wallet holds cash or credit cards. Instead, they read the blockchain ledger to show you the balance in your crypto address. And when you make a transaction, they communicate with the ledger to update the balance in your wallet and the recipient’s wallet.
Do you need a crypto wallet?
That depends. Wallets are secured by private keys and are generally considered the safest storage option compared to simply leaving funds on an exchange. As the popular saying goes, “not your keys, not your crypto.” Wallets allow you to retain complete control over your funds instead of leaving security up to an exchange.
However, many users choose to leave their crypto on exchanges because it’s more convenient for trading. Instead of transferring your assets back and forth between your wallet and an exchange, crypto that stays on an exchange can be traded at a moment’s notice. It also cuts down on transaction fees and the possibility of sending your crypto to the wrong address.
If you choose to store your crypto in a wallet, you’ll need to decide between a custodial or non-custodial wallet.
Custodial wallets
Custodial wallets are offered by most cryptocurrency exchanges. The exchange, not the user, holds the private keys.
This means that the exchange is fully responsible for the wallet's security and must maintain strict authentication measures to prevent wallets from being hacked.
Pros
· Convenience – can be accessed with a standard username and password
· Accounts can be recovered even if passwords are lost
· Transaction fees within the same platform are lower or eliminated
· May be covered by insurance
Cons
· User isn’t in control of their own funds
· Exchange may be hacked or forced to comply with government regulations
· Slower withdrawals due to internal security checks
· There may be higher fees for withdrawing or transferring funds to a different platform
Non-custodial wallets
Funds stored in non-custodial wallets aren’t controlled by any institution. Instead, only the user can access the wallet by using their unique private keys.
Non-custodial wallets are free from censorship or confiscation. However, they require a much greater level of responsibility on the user's part.
Pros
· Users are in complete control over their own funds
· Funds can’t be confiscated by an exchange or government
· Faster withdrawals or transfers
Cons
· If a user loses their private keys, they lose permanent access to the wallet
· Transferring assets between a wallet and exchange incurs fees
· No insurance if the wallet is hacked
There are two main types of non-custodial wallets: cold wallets and hot wallets. The primary difference between the two is the amount of time they spend connected to the internet. Cold wallets aren’t connected to the internet, while hot wallets are always connected to the internet.
Let’s dive deeper into these two types of wallets.
What is a cold wallet?
A cold wallet isn’t connected to the internet. This is typically a more secure, less convenient option than a hot wallet. Since cold wallets remain offline, they can’t be targeted by hackers. Nor is there a risk of a bug in the software that leads to a loss of funds.
Cold wallets are best for storing crypto long-term when you don’t need to access funds regularly for quick trades or frequent payments.
There are two types of cold wallets: paper wallets and hardware wallets.
· A paper wallet is simply a piece of paper or metal where a wallet’s public and private keys are recorded. Since a paper wallet is never connected to the internet, it keeps the keys safe from phishing attacks or hacking attempts.
· A hardware wallet is an external device that usually connects via USB or Bluetooth. This device stores your keys and is designed to be immune to hacking, even when connected to your computer.
Two of the most popular hardware wallets are Ledger and Trezor. Both are excellent storage options that provide the highest security standards. However, there are a few differences that may appeal to certain users.
Ledger wallets support Bluetooth connectivity and a mobile app compatible with both Android and iOS. Ledger wallets offer great features for users who want to make transactions on the go.
Trezor wallets are open-source, which may be an advantage to users concerned with transparency issues. The higher-end models also feature a color touchscreen, offering an excellent user experience.
So, who should use a cold wallet? If your priority is security, a cold wallet is the best option. Cold wallets are also better for long-term storage since they offer better peace of mind. If you hold a significant amount of crypto assets, consider investing in a hardware wallet.
What is a hot wallet?
A hot wallet is connected to the internet and exists as a web-based platform or software. Since they’re always online, they’re more convenient for conducting transactions than cold wallets. However, they’re also more susceptible to hackers who may target users in phishing attacks or other scams.
There are four main types of hot wallets.
· Cloud wallets exist as web applications and can be accessed from multiple devices. They offer the highest level of portability and flexibility but may sacrifice a degree of security.
· Mobile wallets are stored on a mobile device. They are non-custodial wallets that allow users to make crypto transactions from anywhere.
· Desktop wallets are non-custodial and considered more secure than mobile wallets but less secure than hardware wallets. Some also offer access to crypto exchanges directly within the application so that you can trade while still controlling your private keys.
· Hybrid wallets combine web and software wallets. Most of the account information is stored on the cloud, but the private keys remain on the desktop or mobile software.
So, who should use a hot wallet? Opt for a hot wallet if your priority is convenience and transaction speed. It’s the best option for frequent traders or users who often interact with dapps or DeFi platforms.
In addition, hot wallets offer a simpler user experience for crypto beginners. If you don’t hold enough crypto to justify investing in a hardware wallet, a software wallet is an excellent option.
Hot wallets vs. cold wallets
When deciding whether to use a hot wallet or a cold wallet, it’s helpful to weigh the pros and cons.
Advantages of hot wallets
· Most convenient option
· Faster, easier transactions
Disadvantages of hot wallets
· More exposed to security threats
Advantages of cold wallets
· Most secure option
· User autonomy
Disadvantages of cold wallets
· Transactions are slower and require a greater learning curve
If you can’t decide which type of wallet is right for you, why not use both? Many crypto users manage their assets by using both hot and cold wallets. After all, you wouldn’t store all of your fiat money in a single wallet. Likewise, it’s safer to spread your crypto between more than one wallet.
For example, you could keep a portion of your assets in a hot wallet used for frequent trading or online purchases. This way, you could conveniently transfer funds in and out as needed.
At the same time, you could keep the remainder of your portfolio in a cold wallet for long-term storage. This ensures that any assets you don’t need for immediate activities are stored in the safest manner.
If you do choose to keep your crypto in the custody of an exchange, make sure you do your research first. Only trust your funds with a provider that maintains the highest cyber security standards and doesn’t have a history of hacks or data breaches.
There’s no single approach that will suit every crypto user. Since cryptocurrency prioritizes individual freedom and personal responsibility, it’s up to you to decide how to best manage your assets.