The number of people holding cryptocurrencies today is higher than ever before. For instance, Blockchain.com’s wallet usage reached 81 million in 2022. Similar service providers are recording equally impressive numbers.
Cryptocurrencies, especially bitcoin, increased in popularity during the coronavirus pandemic as people sought alternative means to beat inflation. Accordingly, demand for crypto wallets grew – because people have to keep the coins somewhere safe.
While knowledge of crypto is improving worldwide, few people understand related aspects, such as crypto wallets. If you’re reading this, count yourself a part of the growing population whose crypto-sophistication level is improving. This article goes under the hood to explain and describe crypto wallets with a particular focus on the difference between hot and cold wallets.
What is a cryptocurrency wallet?
In the traditional sense, a wallet is a bag or case for holding money. Note that, in this case, the wallet is a ‘thing’ because it holds physical money – banknotes, coins, or bank cards. But what does it become when the money ceases to be a thing?
Cryptocurrency is a digital asset domiciled on a blockchain platform. Accordingly, a crypto wallet is a software that allows you to store and transfer cryptocurrency. The wallet could be a device, such as a flash drive or a mobile or desktop platform program. But the differences with physical wallets do not end there.
For example, crypto wallets do not carry the actual coins, even in their digital form. Instead, the device or program merely holds the keys to your coins. Let’s explain further:
Cryptocurrency is digital money used in a centralized or peer-to-peer system to transfer value, such as Bitcoin. Technically, crypto is encrypted data hosted on a blockchain network. To move or alter the data, one must have the proper credentials and permissions; otherwise, the process will not succeed.
This is where the concept of keys comes in. In cryptography, a key is a technology that validates the authenticity of data through encryption and decryption. When transacting in the cryptocurrency ecosystem, you’ll come across two keys – public and private keys.
- Public key – this works similarly to an address that identifies you when transacting with crypto. Think of it as a bank account number or an email address that enables you to send and receive messages. As such, the key is sharable.
- A private key is a string of numbers and letters that should be kept secret. If the public key is the bank account/email address, the private key is the password that gives you access to the account. When sending or receiving crypto coins, the private key identifies you as the rightful owner of the crypto wallet, and the transaction should proceed.
What about hot and cold wallets?
We know that crypto wallets do not store actual coins, but instead, they hold the keys to the assets. The wallets merely facilitate your interaction with the blockchain that hosts the cryptocurrency. Specifically, they let you move coins elsewhere and allow others to see the balance in your wallet, and vice versa.
As you interact with crypto wallets further, you’ll notice variations. For example, we already mentioned that the wallet could be software installed on a desktop computer or smartphone or a device such as a flash drive. Consequently, one can place crypto wallets into two broad categories: hardware and software wallets.
- Hardware wallets include wallets that are physical devices that users can plug into a computer to complete transactions.
- Software wallets are pieces of software installed on a smartphone or desktop.
But what about hot and cold wallets? A hot wallet is one that users can access if only there is internet access. The holder’s keys are held in a secure web server accessible online. Also, the hot wallet can fall into either of the two broad categories of crypto wallets.
On the other hand, a cold wallet is what you might have already guessed, a crypto wallet accessible offline. The holder’s keys are stored locally, on the desktop, smartphone, a flash drive, or even a piece of paper. A typical cold wallet falls under the hardware crypto wallet category.
Hot vs. cold wallets
Besides accessibility online or offline, hot and cold wallets differ in many other ways that we will explore here.
Hot crypto wallets
Hot wallets are sometimes called web-based wallets, and they are also the most common. To understand why they are familiar, let’s consider an illustration.
Suppose you sign up for an account on a crypto exchange, such as Coinbase. Usually, most crypto exchanges offer to store the coins for you in custodial wallets. But let’s say you download a desktop wallet on your computer or an app on your smartphone because it is fast and straightforward to set up – you’ll be setting up a hot wallet.
Pros of hot wallets
- Hot wallets are always connected to the internet, thus easy to use. For example, some hot wallet service providers offer them as browser extensions, making access a tap or click away.
- Also, hot wallets are easily accessible and convenient. Think of the smartphone application. You always carry your mobile phone around, and there is no chance you’ll need to access your wallet only to realize that you left the phone at home.
Cons of hot wallets
- Hot wallets are not ideal for holding large amounts of crypto because of an elevated risk of hacking. The fact that hot wallets are always online means hackers have the time to fiddle around for unauthorized access.
- To some extent, users do not have complete control over their coins. We know that hot wallets store users’ private keys on a secure web server operated by a hot wallet service provider. If bad actors hijack the service provider’s equipment, users are likely to lose their keys.
Cold crypto wallets
A cold wallet is anything where you can access your keys without internet access. It includes a piece of paper with your public and private keys written on it.
Suppose you buy Bitcoins from your favorite exchange and, instead of downloading a browser extension for storing the coins, you order a USB stick, such as Ledger, from Amazon. You’ll then hook the device to your computer and complete the transfer of the coins. While at it, you’ll notice that the device will ask for a passcode before giving you access. Thus, you must have the physical device in hand and the passcode to use the cold wallet.
Pros of cold wallets
- Security is cold crypto wallets’ strongest suit. We saw that they are accessible offline, hence unsusceptible to internet-based bad actors. Also, there is an extra layer of security, the passcode. Your coins are entirely safe if you can keep the passcode secret.
- Cold wallets give you complete control over your keys and the coins because everything is stored locally.
- Because of the solid security, cold wallets are ideal for storing a massive amount of crypto. In fact, this is the preferred storage method for many crypto-related businesses, such as exchanges.
Cons of cold wallets
- Cold wallets are inconvenient and almost impractical for everyday usage. A typical crypto holder wants to take advantage of price swings in the market. However, the cumbersome nature of moving coins from a cold wallet impairs users’ ability to exploit the full potential of crypto price fluctuations.
- Users have greater responsibility to guard the coins. If anything goes wrong, say you lose the passcode to the USB stick or recovery phrase, you assume 100% liability. On the contrary, hot wallet service providers might refund users if hackers compromise their webservers.
Which wallet should you choose?
Your choice of an ideal crypto wallet heavily depends on various factors. For example, what is the goal for buying crypto?
A cold wallet seems appropriate if you acquire the coins to ‘HODL.’ HODLing (short for Hold On Dear Life) is a cryptocurrency investment strategy where investors sit on their coins through various cycles – recession and appreciation – and would only sell at a price that generates sufficient returns. In such a case, there is no immediate need to transfer the coins, which makes sense to store them in a cold wallet.
However, a hot wallet would be ideal if you intend to play the market volatility. This investment strategy involves frequent buying and selling the given crypto to cash in on the fluctuating prices. Thus, you’ll need easy access to the coins because sometimes you might need to make several transactions in a day.
Is it possible to get the best of both worlds? So far, the market does not have wallets with both hot and cold characteristics, and perhaps it is because such a feat would be impossible. A wallet is either hot or cold; no two ways about it.
Nevertheless, people have developed ingenious tricks to achieve the impossible. A great example would be to use a dedicated mobile phone as a crypto wallet. You’d download a hot wallet onto the phone and only turn it on when it is time to make a transaction. So, the wallet is cold when the phone is off and becomes hot when you switch on the phone and connect it to the internet. Genius.