Cryptocurrency traders and investors gravitate toward different crypto wallets. So which kind is the best?
Let’s settle the cold wallet vs hot wallet debate once and for all!
What Is a Cryptocurrency?
Before we look into the hot vs cold wallet matter, we should first clarify what cryptocurrency is.
A cryptocurrency is a decentralized digital currency.
No single entity (government, corporation, or individual) can control one. Instead, a cross-border network of computers validates crypto transactions and protects the ledger’s integrity.
Cryptocurrencies can be as private as physical cash. They can also be as fungible, divisible, countable, transportable, and durable as electronic fiat currencies.
As of 2021, there are more than 4,000 cryptos in existence. Bitcoin is the most popular of the bunch, as it’s the first and the most recognizable one. And among other cryptocurrencies (altcoins), Ethereum is the largest by market capitalization.
You can buy, trade, save, lend, and borrow against cryptocurrencies like regular money. You can even mine some yourself. This can be a rewarding venture if you can protect yourself from cryptojackers.
It’s impossible to explain the essence of cryptocurrency in 130 words. So, feel free to check out our in-depth guide for beginners to learn the basics.
What Is a Crypto Wallet?
The term wallet implies that it stores assets. This creates a common misconception, though.
Hot and cold wallets are specialized tools for using and managing your cryptocurrencies.
How Does a Crypto Wallet Work?
Technically, hot and cold wallets interact with blockchains. Each one uses a special algorithm to create a unique private key to the crypto asset it supports.
Also, it creates the public key needed to decrypt your transactional data. The decoded information allows a crypto network to verify your private key without seeing it.
In addition, a public key generates a wallet address. It’s the information other parties need to send you a particular crypto asset.
A wallet address is safe to share publicly. It doesn’t reveal the contents of the corresponding crypto wallet. It’s similar to your email address that doesn’t provide other people access to your inbox.
Now that you know what a private key is for, it’s clear to see what a cryptocurrency wallet really is. It’s a keychain.
Hot and cold storage wallets keep private keys (not cryptocurrencies), as you can’t actually obtain crypto assets. They’re permanently stuck on their blockchain.
What you can keep are the private keys. They give you the right to use the assets your crypto wallets contain.
The crypto community has used the term wallet for simplicity. Keychain may cause more confusion, as public-key cryptography requires a lengthy explanation most people aren’t interested to hear. The concept of wallet-stored money, on the other hand, is universally understood.
What Are the Different Types of Crypto Wallets?
Generally, there are two ways to classify cryptocurrency wallets — custody and coldness.
This piece is about the hot wallet vs cold wallet advantages and disadvantages. But let’s briefly discuss the difference between custodial and non-custodial crypto wallets.
Custodial (hosted) cryptocurrency wallets are under the control of a third party.
Basically, they are no different from banks. They hold your private keys and are responsible for protecting them from theft.
The first crypto wallet you’ll likely use is of this kind.
Non-custodial (or self-custodial) crypto wallets give you total control over your private keys.
With this type of wallet, you can be your own bank. You don’t have to trust any other party to handle and manage your funds.
Taking personal responsibility for your private keys sounds like a lot of work — and it is. But it’s a necessary step toward financial freedom.
The point of cryptocurrency is to decentralize the financial system. So if you use non-custodial hot and cold storage cryptocurrency wallets, you’ll be contributing to the cause.
Sadly, many of us aren’t prepared and/or willing to fully handle our finances ourselves. We still like to rely on intermediaries to make life easier for us.
Comfort comes at a price, though. You have to give up some of your power to enjoy it. Entrusting other parties with your assets seems harmless since we’re used to it. But it can backfire on you if things go sideways.
Just ask the Venezuelan authorities.
Initially, the Nicolás Maduro administration couldn’t get ahold of the economically devastated country’s gold reserves in the Bank of England. The High Court in London ruled that the United Kingdom government shouldn’t recognize Maduro as the legitimate Venezuelan president.
Regardless of your country’s politics and economics, giving a centralized intermediary to control your assets is dangerously comfortable. When you understand the practicalities of DeFi (decentralized finance), you can see why it matters to use non-custodial crypto wallets.
What Is the “Hot Wallet vs Cold Wallet” Debate?
Now, let’s move on to the second cryptocurrency wallet classification: coldness.
It refers to internet exposure.
The less a crypto wallet needs to go online to function, the colder it is.
The general consensus in the crypto community is that high internet exposure is a major threat to private key security.
However, the usefulness of cold key storage solutions to everyone is debatable. They may even endanger your funds.
Do you want to know both sides of the cold wallet vs hot wallet argument? Keep reading!
What Is a Cold Wallet?
A cold crypto wallet is one that stores private keys in an offline environment. Usually, it comes in two forms — paper and hardware.
A paper wallet is a printed piece of paper that contains a pair of private and public keys in the form of a QR code.
It was a popular crypto cold storage solution in the early days of Bitcoin.
You can generate a paper wallet offline (the only advisable way to do so). You only need a piece of crude technology to come up with your own private key.
In theory, you can produce one by flipping a coin 256 times and jotting down the binary digits. And voilà — you have a random 256-bit Bitcoin private key.
Then, you can feed it into a particular computer program and make a corresponding public key and wallet address.
To build a secure paper wallet, you should use a brand-new computer that has never been connected to the internet. You shouldn’t plug any storage device that has ever been online into the said machine either.
When choosing a printer, use one that’s memory-less and isolated from the internet.
You can also use one of the specialized sites for generating a cold wallet for Bitcoin. Such tools can randomly create keys and QR codes more quickly.
You should go offline after loading the webpage with the tool and while generating the data you need. Afterward, you have to erase your browsing history post-key generation.
Notably, you should always spend all of the funds from your paper crypto wallet.
Once used, you can presume that your private key is no longer secure. If you spend part of the funds only, move the change to a brand-new secure paper wallet.
As you can see, using a paper crypto wallet is quite problematic. Without technical expertise and a deep understanding of all possible vulnerabilities, you’ll likely fail. You may fall into a false sense of security and probably lose your private key to malicious parties.
If generated properly, a paper wallet can deliver reliable cold storage for crypto. But most people lack the necessary skill and/or equipment to build one flawlessly and consistently.
A hardware wallet is a physical device that can store private keys to multiple crypto assets and create wallet addresses.
The only other job of its software is to sign transactions.
Usually, this kind of cryptocurrency cold wallet has a tiny screen and a few buttons. It may even mimic the look of everyday objects to avoid suspicion.
A hardware wallet is simplistic by design to keep cybersecurity threats to a minimum. Because of this, it needs other equipment (like a desktop or a smartphone) to help facilitate transactions.
Using a USB cable, Bluetooth, or some other means, you can link a hardware wallet to a secondary device. The latter goes online, prepares the crypto transactions you initiate, and passes the data to the hardware wallet, which then transmits the signed data back to the secondary device.
Throughout the process, it leaks no sensitive information to cyberspace.
When sending funds from a hardware wallet to any other crypto wallet, you can verify the address on the screen. You can compare the information displayed on your hardware wallet and the one shown on the secondary device.
This way, you can make sure that you’re sending the crypto to the right party. Also, this capability lets you detect a tampered device and halt the transaction if you think that something’s wrong.
What Is a Hot Wallet?
By definition, a hot crypto wallet is one that’s exposed to the internet. Typically, it’s software that resides on a cloud server, a desktop (or laptop), or a mobile device.
Otherwise known as web-based types of wallets, cloud wallets exist on online platforms controlled by centralized entities.
They don’t have their own apps. But you don’t necessarily need a browser to use them. You can transact with them through the apps owned by the financial intermediaries that operate them. So, cloud wallets are almost always custodial by nature.
Desktop and Mobile Wallets
These hot wallets are apps you can download to a local electronic device you own. The beauty of them is that they’re non-custodial. Even their developers have no access to the private keys stored in them.
Cold Wallet vs Hot Wallet
Neither of these wallets is suitable for everyone, nor should you use either for every activity.
Some are better at everyday transactions, whereas others make more sense for long-term key storage.
To help you understand which kind of wallet to use for which purpose, let’s shed light on the cold wallet vs hot wallet benefits and drawbacks.
Pros of Cold Wallets
These wallets are ideal for protecting your crypto investments for a long period. Below are their indisputable advantages.
Paper and hardware wallets are immune to cyberattacks.
Hardware wallets offer different levels of wallet security. Apart from being PIN-protected, they use a seed phrase as a backup of private keys.
A seed phrase is a recovery password. It consists of 12 or 24 English words that can transfer your private keys into a new hardware wallet.
This could be useful if you lose your wallet by accident, to a thief, or because of device failure. A seed phrase can also give you peace of mind if your wallet’s manufacturer goes out of business.
When you buy a new device that supports your old wallet’s seed phrase, you can enter it upon setup. Then, if successful, you can reclaim your keys and manage your crypto balances as nothing happened.
The best digital wallet vendors offer an advanced feature called a passphrase. It serves as a secondary password that lets you access crypto accounts that don’t appear by entering just the PIN.
You can think of it as an extra word to your seed phrase. When changing hardware wallets, make sure your new one supports passphrase to get ahold of your secret crypto accounts.
Some hardware wallet models are engineered with full air gapping in mind. In addition, most vendors thoughtfully use tamper-evident packaging to help you see whether your device has been compromised in transit.
If you’re a technical user, you should strongly consider paper wallets to completely secure your crypto assets.
Under the right conditions, paper can preserve its integrity for decades, if not centuries.
The developers of cold storage wallets don’t have any KYC (Know-Your-Customer) policy. In other words, you can use their products without going through identity verification.
At most, you’ll need to share an email address to place your order and/or set up an account.
Anyone is free to use paper and hardware wallets. We can’t say the same about centralized trading platforms that discriminate against users from certain jurisdictions to avoid upsetting regulators.
You may find it extremely difficult to obtain a cryptocurrency cold wallet if your government dislikes crypto.
The latest hardware wallets enable you to store a huge array of cryptocurrencies from various sources. As a result, these devices are perfect for diversifying your portfolio and investing in assets outside the top cryptos.
Cons of Cold Wallets
Putting the private keys to your crypto assets in cold storage is ideal. But it may not be necessary due to many reasons.
Altcoins and Bitcoin in cold storage are not as easy to convert into cash as those in hot wallets.
Not all cryptocurrencies make good mediums of exchange. For example, during severe network congestion, a Bitcoin transaction can take days or even weeks to get a confirmation.
Cryptocurrency prices can fluctuate significantly throughout the day. So, struggling to turn your money from crypto into fiat can result in a loss.
Hardware wallets aren’t free. One might not be worth the expense if you can afford to lose your crypto investments to hackers.
Regarding the ease of use of hot wallet vs cold wallet options, the former wins any day. Using a bank is so much simpler than being your own bank.
There’s no avoiding the difficulties of using paper and hardware wallets. So, there’s always a possibility that you may mess up along the way.
A loss of funds is one of the dangers of altcoin and Bitcoin cold wallet mismanagement. Mistakes like producing a digital backup of your seed phrase are an invitation to a data breach.
Nobody can help you if you lose access to your non-custodial cold wallet or leak your private keys.
Hardware wallet vendors may provide customer support for answering pressing questions and troubleshooting technical issues. But the assistance they can offer is limited.
Pros of Hot Wallets
As follows are the two main reasons why most crypto investors and traders use these types of wallets.
Hot wallets facilitate transactions. That’s why funds stored in them are painless to convert into your local currency.
If cryptocurrencies become legal tender everywhere outside El Salvador, you may never have to exchange them for fiat money. But until then, you need hot wallets to take profits and/or cut losses in your crypto investments.
The custodial nature of types of crypto wallets makes them relatively easy to use. Without being personally responsible for private key management, you can invest in crypto with less stress.
Cons of Hot Wallets
If you’ve accumulated relatively large amounts of cryptos, it would be wise to depend less on hot wallets. Here’s why:
A popular crypto saying goes: “not your key, not your crypto.”
The centralized entity that controls your hot wallet may freeze your account and stop you from withdrawing your funds.
The custodian of your private keys may run away with them and disappear on you too.
Some crypto exchange owners have done or attempted to do it in the past. QuadrigaCX and Thodex are two notable examples. It could happen again.
You have no choice but to trust a centralized trading platform you intend to use. So, we advise you to go with trustworthy cryptocurrency exchanges and brokers only.
Susceptibility to hacking
These types of cryptocurrency wallets are always the target of heists. There’s no shortage of horror stories about crypto exchanges getting hacked.
That’s why today’s cryptocurrency trading platforms employ a multitude of wallet security measures. Their operators can’t stop cyberattacks, but they can deter and neutralize hackers.
Some of them also insure the investors’ funds in their custody as a form of reassurance.
How to Choose a Bitcoin Wallet
No two Bitcoin wallets are exactly the same.
It pays to be selective about which ones to use. Picking the wrong ones can needlessly cost you tons of money one way or another.
How do you know that you’ve found the right Bitcoin wallets? Here’s some advice:
Check Out All of The Features
Find out every single thing your prospective hot and/or cold storage wallet can and can’t do. This way, you assess its utility, security, flexibility, and reliability.
Ideally, you should look for a non-custodial Bitcoin cold wallet that:
- has a built-in exchange functionality
- bundles transactions
- adjusts transaction fees
- can replace unconfirmed transactions with higher fees
- allows air gapping
- supports a seed phrase, a passphrase, and two-factor authentication
When it comes to custodial Bitcoin wallets, go with centralized entities that take security seriously and charge the most reasonable fees.
Dig Up Past Scandals
All brands in the crypto space would put their best foot forward. But even the most established and most trusted ones have had their fair share of bad press.
For instance, the creator of one of the best digital wallets on the market made headlines after falling victim to a data breach. The company lost no private keys. But the incident exposed the email addresses of one million users.
No company or technology is perfect. But at least find out your prospective Bitcoin wallet’s reported shortcomings and fixes before depositing funds into it.
Be Aware of The Risks
There’s no such thing as a 100% risk-free Bitcoin wallet.
Desktop or cloud-based wallets are the least secure. Mobile software wallets are decent. And hardware wallets are the most robust.
However, you can still lose your private keys even if you keep them on an air-gapped Bitcoin cold storage wallet.
As a general rule, you shouldn’t use a Bitcoin wallet whose complexity exceeds your ability to maximize its security features.
Apart from cyber threats, you should also consider physical dangers. For example, moisture, fire, and wildlife can damage your hardware wallet and handwritten backups.
Talking about your crypto investments in public may put your funds in jeopardy too.
Lastly, forgetting to tell another person you trust about your holdings is maybe the worst mistake you can make. Instructing this individual how to access or recover your funds is also a must.
In case something happens to you, your inaccessible private keys can remain untouched forever. And you may not be able to pass down your Bitcoin and/or altcoins to your heirs.
Hot and cold types of cryptocurrency wallets have distinctive strengths. But they can’t go without their own set of weaknesses.
The key is to capitalize on the positives of one in order to offset the negatives of the other.
Find the right balance between both wallets to meaningfully secure your private keys and manage your funds with no stress.
Coinbase is a hybrid. It uses custodial hot and cold wallet types.
Ninety-eight percent of the assets it holds for its users are in cold storage. It keeps only 2% of the funds in hot wallets to minimize any loss in case a cyber attacker strikes.
You can also use Coinbase Wallet. It’s a non-custodial software wallet designed for DeFi. It enables you to completely control your private keys and use decentralized crypto-based financial platforms.
No, they’re not. However, cold crypto wallets are not without risks, either.
Paper wallets are prone to damage due to moisture, fire, and termites. Also, if unwanted parties know their existence and locations, they can end up in the wrong hands.
Hardware wallets are safe from malware, but they’re not indestructible. For instance, you may lose your private keys (and your funds) if you don’t properly safeguard the backups of your wallet’s seed phrase (and passphrase, if you use one).
Cold crypto wallets have the edge in terms of security, control, privacy, permissionless, and multi-cryptocurrency support. But when it comes to ease of use, liquidity, and cost, hot wallets usually have the upper hand. So, which one is better depends on your needs and preferences.
Ultimately, it would be unwise to use just one kind of crypto wallet. By using cold and hot wallets accordingly, you can manage your cryptocurrencies more effectively.
Read this article from the beginning to gain more insight into the merits of cold wallet vs hot wallet options.