In traditional finance, money is kept in a bank account, whereas in cryptocurrency, money is kept in an individual “wallet,” some digital, some paper. Like traditional bank accounts, there are cold wallets and hot wallets, each with its distinct uses and advantages.
To choose which type of wallet is right for you — a cold wallet or hot wallet — it can be helpful to compare which features best suit your crypto storage needs.
In this article, we will explore all the aspects of each type of wallet:
- What is a cold wallet?
- What is a hot wallet?
- Cold wallet vs. hot wallet: which is right for you?
Related: Digital assets and cryptocurrency
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What is a cold wallet?
A cold wallet is a digital wallet that allows users to store cryptocurrency offline. The wallet only ever accesses an internet-connected device when the user needs to send or receive funds using the wallet. This makes it an exceptionally secure option for crypto holders.
Unlike traditional currencies, cryptocurrency is not held nor protected by a bank or central governing body thus giving the user full authority over their funds. However, cryptocurrency must be kept somewhere, so individual wallets were created.
Below is an overview of the types of cold wallets.
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1. Hardware wallet
A hardware wallet is a digital wallet that allows users to store cryptocurrency on a physically-detachable device. When the hardware wallet is not in use, it remains disconnected from any other device, disabling any internet, local area network or physical transferability.
When the user needs to send or receive funds using the cold storage wallet, the device connects to an internet-connected computer via a USB cable. Even then, the wallet is only accessible with the correct private key which is generated offline. This adds another layer of security to the already multi-layer encrypted security protocol.
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2. Offline software wallet
Offline software wallets are similar to hardware wallets but are more complex to set up and use. An offline software wallet separates a wallet into two platforms — an offline wallet containing the wallet’s private keys and an online wallet containing the public keys.
The online wallet and offline wallet function separately to initiate new transactions that must be manually processed incrementally by the user. This allows transactions to be sequentially processed without the offline wallet ever connecting to the internet, securing its stored private keys.
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3. Paper wallet
A paper wallet is the most basic form of cold storage. It is an actual paper document with the public and private keys written or printed on it, using an offline printer. A paper wallet typically features a QR code to be easily scanned and signed to process transactions.
Paper wallets are effective cold wallets; however, they are susceptible to being lost, damaged, illegible, destroyed, copied or stolen, rendering the wallet’s funds irrecoverable.
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4. Sound wallet
A sound wallet is an audio device that records and stores a wallet’s private keys in encrypted sound files into mediums such as CDs and vinyl discs. Sound wallets are not common nor popular among cryptocurrency holders, yet they are a viable option for safely storing digital currencies.
To retrieve the keys from a sound wallet, code hidden within these audio files can be deciphered with a spectroscope app or high-resolution spectroscope.
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What is a hot wallet?
A hot wallet is an online storage tool that allows owners of cryptocurrency like Bitcoin to send, receive and store cryptocurrency. Hot wallets are cryptocurrency wallets provided by third-party entities and are connected to the internet. Because they are connected to the internet, hot wallets allow for fast and easy transactions at any time, regardless of location.
Upon creating a hot wallet, users are given a unique public wallet address which is shared with others to receive cryptocurrency, similar to a username or bank account number.
A private key for the wallet is also provided, and functions much like a password. Finally, a recovery seed phrase is provided; this is a sequential list of random words similar to a password recovery secret question’s answer.
Despite the name, hot wallets don’t actually store cryptocurrency in the same way traditional wallets do. Hot wallets are primarily used for temporarily holding a small amount of funds used for everyday buying, trading, or transferring cryptocurrency.
These wallets help facilitate any changes to the record of transactions permanently stored on the decentralized blockchain ledger for any given cryptocurrency.
Below is an overview of the different types of hot wallets.
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1. Wallets on investing platforms
When a cryptocurrency investor creates an account with a digital currency exchange or investing platform, they are provided with a hot wallet protected by the platform. These hot wallets are firmly protected by their respective exchanges, as the company’s success and survival depends on protecting customers’ funds from getting stolen.
Some centralized exchanges may even insure their customers’ funds, providing reimbursement guarantees in the event of a security compromise or loss of funds.
Note that a decentralized exchange, an exchange with no central authority, offers no similar protections and requires users to use their own wallets.
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2. Desktop wallet
A desktop wallet is a computer or smartphone application installed on an internet-connected device that gives the user complete control over their wallet. Desktop wallets have a public address and allow the user to send or receive cryptocurrency, and they also have a private key to protect stored funds.
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3. Web wallet
Web wallets are hot wallets hosted by a company through a website or a web browser extension. Web wallets facilitate access to cryptocurrency from anywhere and are accessible on web browsers or mobile devices.
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4. Mobile wallet
A mobile wallet is similar to a desktop wallet, but is designed for mobile devices such as smartphones or tablets. Mobile wallets allow for mobile payments and transfers in physical stores, via touch-to-pay and scanning of a QR code.
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Cold wallet vs. hot wallet security
Because cold storage stores cryptocurrency through an offline medium, it is the strongest form of security and self-custody for protecting cryptocurrency, similar to storing gold in a vault. Since the funds remain offline when not in use, it is nearly impossible to hack or gain unauthorized access to a cold storage wallet. A cold wallet is only susceptible to being physically lost, damaged or stolen.
While hot wallets can be considered “safe,” they are technically more vulnerable to attacks because they are connected to the internet. Maintaining a constant internet connection provides the opportunity, however small, for malicious actors to gain unauthorized access to and steal funds from wallets even when a wallet isn’t actively being used by the owner.
Hot wallets are ultimately secured by the individual user. There are only two ways to access a wallet: A confidential “private key” and a recovery “seed phrase.”
However, hot wallets ultimately have three attack vectors:
- Back-end: Via an unsecured exchange, web wallet company, a bug in desktop wallet’s code)
- Front-end: If the individual wallet owner saves private key in an email which is then hacked)
- Random: Brute force attack
Experienced cryptocurrency investors typically only keep a small percentage of their holdings in a hot wallet to reduce risk, as hackers are less likely to break into a hot wallet for a small sum of tokens. Hot wallets commonly will only have a small amount of tokens planned to be traded, spent, or sold in the near future. Otherwise, the core remaining assets may remain in a cold storage wallet until needed.
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Cold wallet vs. hot wallet: Which is right for you?
Choosing the right crypto storage can be a difficult task and there might not be one perfect solution. Deciding what kind of wallet to use depends on a multitude of factors such as:
- Accessibility: If the wallet is purely for longer-term storage and will not be used often, a cold wallet with stronger security might make more sense.
- Frequency of use: For someone who needs to access the wallet often for trading, sending, and receiving without much hassle, a hot wallet might be better suited.
- Purpose of use: Spreading cryptocurrency across multiple wallets — with small amounts needed for daily transacting to hot wallets and core holdings not needed for years to cold wallets — can reduce long-term risk and optimize day-to-day transacting.
- Diversity: Individuals are not limited to only one wallet, making it not only possible but potentially advantageous to diversify cryptocurrency investments across multiple wallets.
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The takeaway
When deciding where to store your cryptocurrency, it’s important for an investor to consider what’s more important: security or convenience.
A cold wallet is a cryptocurrency wallet stored on a device or medium that is not connected to the internet. Cold wallets are more secure and difficult to attack, but are inconvenient to use and can be damaged, lost or stolen.
A hot wallet is a digital currency wallet stored on an online device that is connected to the internet. Hot wallets are more suitable for investors who actively buy, send, and trade cryptocurrency and need to be able to easily access their wallet from anywhere, though they are more vulnerable to hacks and loss of funds.
This article originally appeared on SoFi.com and was syndicated by MediaFeed.org.
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