Let’s resolve the dispute about cold and hot wallets once and for all. But, before we consider the issue of hot and cold wallets, we must first clarify what a cryptocurrency is.
Cryptocurrency is a decentralized digital currency.
No organization (government, corporation, or individual) can control it. Instead, a cross-border network of computers verifies cryptographic transactions and protects the integrity of the registry.
Cryptocurrencies can be as private as cash. They can also be interchangeable, divisible, countable, portable and durable, like electronic paper currencies.
According to Coinmarketrate.com as of September 2021, there are more than 11,750 cryptocurrencies. Bitcoin is the most popular of all, since it is the first and most recognizable. And among other cryptocurrencies (altcoins), Ethereum is the largest by market capitalization.
You can buy, exchange, save, lend and borrow in cryptocurrencies like ordinary money. You can even mine some yourself. This can be a profitable venture if you can protect yourself from crypto-jacking.
But for all this, you need a cryptocurrency wallet.
The term wallet implies that assets are stored in it. Hot and cold wallets are specialized tools for using and managing your cryptocurrencies.
How a crypto wallet works
Technically, hot and cold wallets interact with blockchains. Each of them uses a special algorithm to create a unique private key to the crypto asset it supports.
A private key is an extremely long set of numbers that cannot be guessed by brute force. You need this password to perform and encrypt your transactions.
In addition, it creates the public key needed to decrypt your transactional data. The decrypted information allows the crypto network to verify your private key without seeing it.
In addition, the public key generates the wallet address. This is the information that other parties need to send you a certain crypto asset.
The wallet address can be safely shared publicly. It does not reveal the contents. It is similar to your email address, which does not give other people access to your mailbox.
Now that you know what the private key is for, it is clear what a cryptocurrency wallet is. It’s just a keychain.
Hot and cold storage wallets store private keys (not cryptocurrencies), since you can’t actually get crypto assets. They are forever stuck in their block chain. Private keys give you the right to use these assets using your crypto wallets.
The crypto community has used the term wallet for simplicity. A keychain can cause a lot of confusion, since public-key cryptography requires long explanations that most people are not interested in. On the other hand, the concept of money stored in a wallet is understood everywhere.
What are the types of cryptocurrency wallets
Today we are talking about the advantages and disadvantages of hot and cold wallets. But let’s briefly discuss the difference between custodial and non-custodial cryptocurrency wallets.
- Custodial (hosted) wallets with cryptocurrency are under the control of a third party.
Basically, they are no different from banks. They store your private keys and are responsible for protecting them from theft.
The first crypto wallet that you are likely to use is of this type.
- Non-custodial (no storage) gives you full control over your private keys.
With this type of wallet, you can become your own bank. You do not need to involve any other party to process and manage your funds.
Taking personal responsibility for your private keys is a lot of work, and it is. But this is a necessary step towards financial freedom.
This is the meaning of cryptocurrency in the decentralization of the financial system. So, if you use cryptocurrency wallets with hot and cold storage, not related to storage, you will contribute to the cause.
Unfortunately, many of us are not ready or do not want to fully manage our finances on our own. We still like to rely on intermediaries who make life easier for us.
However, you have to pay for comfort. You have to give up some of your freedom to enjoy it. It seems harmless to entrust your assets to others, since we are used to it. But if something goes wrong, it can have unpleasant consequences.
Venezuela is an excellent example.
Initially, the administration of Nicolas Maduro could not keep the gold reserves of the economically devastated country in the Bank of England. The High Court in London ruled that the government of the United Kingdom should not recognize Maduro as the legitimate president of Venezuela. That’s all. Access to the ” wallet” was closed.
Regardless of the politics and economy of your country, providing a centralized intermediary to manage your assets is dangerously convenient. When you understand the practical aspects of DeFi (decentralized finance), you will understand why it is important to use crypto-wallets that are not associated with storage.
The “Hot Wallet versus Cold Wallet”debate
Now let’s move on to the second classification of cryptocurrency wallets: cold.
This applies to access to the Internet.
The less a crypto wallet needs to connect to the network in order to function, the “colder”it is.
The general opinion in the crypto community is that the high availability of the Internet is a serious threat to the security of the private key. However, the usefulness of cold key storage solutions for everyone is debatable. They may even jeopardize your funds.
What is a cold wallet?
A cold crypto wallet is a wallet where private keys are stored in an offline environment. It usually comes in two types – paper and hardware.
- Paper wallets
A paper wallet is a printed sheet of paper containing a private and public key in the form of a QR code. At the dawn of Bitcoin, it was a popular solution for cold storage of cryptocurrencies.
You can create a paper wallet offline (the only recommended way to do this). To create your own private key, you will only need a primitive technology.
Theoretically, you can get it by flipping a coin 256 times and writing binary digits. And voila – you have a random 256-bit Bitcoin private key.
Then you can transfer it to a specific computer program and create the corresponding public key and wallet address.
To create a secure paper wallet, you should use a completely new computer that has never been connected to the Internet. You should also not connect any storage devices that have ever been connected to the network to the specified machine.
You can also use one of the specialized sites to create a cold wallet for Bitcoins. Such tools can randomly generate keys and QR codes faster.
It is noteworthy that you should always spend all the funds from your paper crypto wallet.
After using it, you can assume that your private key is no longer protected. If you spend only part of the funds, move the change to a new secure paper wallet.
As you can see, using a paper crypto wallet is quite problematic. Without technical knowledge and a deep understanding of all possible vulnerabilities, you are likely to fail. You can fall into a false sense of security and probably lose your private key.
When properly created, a paper wallet can provide reliable cold storage of cryptocurrency. But most people lack the necessary skills and patience to create it flawlessly and consistently.
- Hardware wallets
A hardware wallet is a physical device that can store private keys for several crypto assets and create wallet addresses.
The only other task of its software is to sign transactions.
Usually, such a cold wallet for cryptocurrency has a tiny screen and several buttons. It can even mimic the appearance of everyday objects to avoid suspicion. These include Ellipal Titan, BitBox, Trezor, Ledger and others.
The hardware wallet is simplified in its design to minimize cybersecurity threats. Because of this, it needs other hardware (for example, a desktop computer or a smartphone) to facilitate transactions.
Using a USB cable, Bluetooth, or other means, you can link a hardware wallet with an additional device. The latter connects to the network, prepares the cryptographic transactions initiated by you and transfers the data to the hardware wallet, which then transfers the signed data back to the secondary device.
Throughout the entire process, it does not transmit confidential information to cyberspace.
When sending funds from a hardware wallet to any other crypto wallet, you can check the address on the screen. You can compare the information displayed in your hardware wallet and the information displayed on an additional device.
This way, you can be sure that you are sending cryptocurrency to the right party. In addition, this feature allows you to detect a hacked device and stop the transaction if you think that something is wrong.
What is a hot wallet?
By definition, a hot crypto wallet is one that is available on the internet. As a rule, this is software that is located on a cloud server, a desktop (or laptop) computer or a mobile device.
- Cloud Wallets
Cloud wallets, also known as web wallets, exist on online platforms controlled by centralized organizations.
They don’t have their own apps. You don’t have to go to browser to use them. You can make transactions with them through applications owned by financial intermediaries who manage them. Thus, cloud wallets by their nature are almost always custodians.
- Desktop and mobile wallets
These hot wallets are applications that you can download to your local electronic device. A striking example is SpaceBot. Their beauty is that they are not associated with the deprivation of financial freedom. Even their developers do not have access to the private keys stored in them.
Cold Wallet vs. Hot Wallet
None of these wallets can be ideal for all needs, and you should not use them for all types of activities. Some are better at handling everyday transactions, while others make more sense for long-term key storage.
To help you understand which wallet to use for what purpose, let’s look at the advantages and disadvantages of cold and hot wallets.
Advantages of cold wallets
These wallets are ideal for protecting your cryptocurrency investments for a long period. Below are their undeniable advantages.
- Computer security
Paper and hardware wallets are immune to cyber attacks. Hardware wallets offer different levels of wallet security. In addition to PIN protection, they use the initial phrase as a backup of the private keys.
The initial phrase is the recovery password. It consists of 12 or 24 English words, with which you can transfer your private keys to a new hardware wallet.
This can be useful if you accidentally lose your wallet due to a thief or due to a device failure.
Developers of cold storage wallets do not adhere to the KYC (Know-Your-Customer) policy. In other words, you can use their products without going through an identity check.
In the best case, you will need to provide an email address to place an order or create an account.
- Without permission
Anyone can use paper and hardware wallets. We cannot say the same about centralized trading platforms that discriminate against users from certain jurisdictions in order not to upset regulators.
It can be extremely difficult for you to get a cold wallet for cryptocurrency if your government does not like cryptocurrency.
Local authorities can use geographical restrictions to block sites selling hardware wallets.
- Multi-currency support
The latest hardware wallets allow you to store a huge number of cryptocurrencies from various sources. As a result, these devices are ideal for diversifying your portfolio and investing in assets that are not included in the top cryptocurrencies.
Disadvantages of cold wallets
It is ideal to store the private keys of your crypto assets in a cold storage. But this may not be necessary for many reasons.
Altcoins and Bitcoin in cold storage are not as easy to convert into cash as in hot wallets.
Not all cryptocurrencies are good means of exchange. For example, during a serious network overload, a bitcoin transaction may take several days or even weeks to receive confirmation.
Cryptocurrency prices can fluctuate significantly during the day. Thus, attempts to turn your money from cryptocurrency into fiat money can lead to losses.
Hardware wallets are not free. It may simply not pay off if you don’t need such a complex storage process. Well, if you don’t have a fortune in the crypt, and you’re not a whale.
As for the ease of using a hot wallet compared to a cold wallet, the first one wins unconditionally. Using a bank is much easier than being your own bank.
It is impossible to avoid the difficulties associated with the use of paper and hardware wallets. So there is always a chance that you will screw up.
The loss of funds is one of the dangers of improper management of cold wallets. Errors such as creating a digital backup of the original phrase are an invitation to a data leak.
No one can help you if you lose access to your cold wallet, which is not related to storage, or leak your private keys. Hardware wallet providers can provide support to customers by answering urgent questions and eliminating technical problems. But the help they can offer is limited.
Advantages of hot wallets
Below are the two main reasons why most crypto investors and traders use these types of wallets.
Hot wallets facilitate transactions. That is why the funds stored in them are painlessly converted into your local currency.
If cryptocurrencies become legal tender everywhere outside of El Salvador, you may never have to exchange them for paper money. But until then, you will need hot wallets to fix profits or reduce losses in your cryptocurrency investments.
Storing cryptos on this type of wallet makes it relatively easy to use. Without taking personal responsibility for the management of private keys, you can invest in cryptocurrency with less stress.
Disadvantages of hot wallets in
If you have accumulated a relatively large amount of cryptocurrency, it would be wise to depend less on hot wallets. Here’s why:
A popular cryptocurrency saying says: “Not your key, not your cryptocurrency”.
A centralized organization that controls your hot wallet can block your account and prevent you from withdrawing your funds.
The keeper of your private keys can escape with them and disappear along with your funds. Some crypto exchange owners have done or tried to do this in the past. QuadrigaCX and Thodex are two striking examples. It could happen again.
You have no choice but to trust the centralized trading platform that you are going to use. Therefore, we advise you to contact only reliable cryptocurrency exchanges and brokers.
- Vulnerability to hacking
These types of cryptocurrency wallets are always the target of robberies. There is no shortage of terrifying stories about hacking cryptocurrency exchanges.
That’s why modern cryptocurrency trading platforms use a lot of wallet security measures. Their operators cannot stop cyber attacks, but they can deter and neutralize hackers.
Some of them also insure investors ‘ funds held in their custody as a guarantee.
Hot and cold types of cryptocurrency wallets have distinctive features that can be considered as advantages. But they can’t do without their weaknesses.
The point is to capitalize on the positive aspects of one in order to compensate for the shortcomings of the other.
Find the right balance between both wallets to securely protect your private keys, and manage your funds without problems.