In the cryptocurrency world, a wallet is a piece of software or hardware that stores the cryptographic keys necessary to access your assets stored on the blockchain. Those keys consist of a private and public pair. The latter identifies the wallet, allowing it to receive tokens without revealing the identity of the owner. The private key, meanwhile, is what gives you access to the wallet – whether that’s to check balances or perform transactions.
While asking someone the temperature of their wallet in the real world might draw some blank stares when it comes to crypto wallets that’s perfectly appropriate, as they fall into two categories: hot and cold. So just what is the difference between the two and why would you favour one over the other?
This category ranges from mobile wallets to desktop programmes and web-based solutions such as accounts with crypto exchanges. Think MetaMask or Coinbase Wallet, to name two popular examples. The key defining feature is that they are connected to the internet, meaning all are vulnerable to online attacks. Levels of security differ hugely within the category, however, with web-based wallets generally being deemed among the least secure as they are vulnerable to security breaches.
That being the case, why use a hot wallet? Ease-of-use. The fact that a hot wallet is always online means there is no impediment to making cryptocurrency trades, purchases and transactions – unlike with a cold wallet, which needs to be plugged in and currency moved out of before a purchase can be made.
It’s good practice to not store too much in a hot wallet, however, owing to the aforementioned security concerns. The analogy that is often deployed is to treat a hot wallet as you would the one you store in your pocket – just enough cash to get by without it being a devastating loss if you lose it.
If a cold wallet is connected to the internet, it stands to reason that a cold wallet is not. Cold wallets include physical cryptocurrency with private keys printed under tamper-proof stickers, or even simply writing down your private and public key pair and storing it on a piece of paper.
When you hear cold wallets being discussed, however, usually what’s being referred to is a hardware wallet. These devices often look like USB sticks only with a screen and buttons – as popular examples from Ledger attest. Such devices store cryptocurrencies internally, meaning a bad actor would need to physically have the cold wallet as well as the PIN code to gain access to them.
Adding and removing currencies is a question of connecting it to a computer. You might think this would be the moment of greatest vulnerability, but all transactions are completed in-device, meaning it is impossible to hack remotely.
So far, so good, but there are downsides. Firstly, you have to stump up the funds, and as a physical object, cold wallets open up the danger of the keys to your cryptocurrency being stolen or even accidentally discarded – we’ve all heard the horror story of the guy who threw away a hard drive containing a fortune in Bitcoin.
With hardware wallets, that wouldn’t be the end of the world, however. Recovery phrases allow the funds held inside hardware wallets to be restored elsewhere – meaning protecting the recovery phrase is almost more important than the wallet itself.
The exact amount you might be comfortable with storing in a hot wallet depends on the reputation of the exchange you are using. Reputable exchanges will be using a system of cold wallets in the background, keeping their customers’ funds offline, with a certain amount stored online for withdrawals.
It’s worth also considering providing some means of accessing your wallets, hot and cold, to loved ones if you are incapacitated for whatever reason. After all, if you are the only one who knows how to access your cryptocurrency, then those funds could well die with you.
Ultimately, it’s a combination of both hot and cold wallets that is the best approach. The actual balance of hot and cold will be dependent on your approach – and how much you value security versus functionality. For those who want to sit on vast amounts of cryptocurrency, clearly, there is an incentive to maintain cold, hardware wallets, while frequent traders of smaller amounts will favour hot wallets they can quickly move coins in and out of.
Not only that, but it might be a good idea to have multiple examples of each category for different purposes – storing a certain amount with an exchange you frequently use, storing currency you plan to hold for a long time on a hardware wallet and using a mobile or desktop wallet for more speculative purchases. The choice is yours!