Cold Wallet vs. Hot Wallet: Benefits and Differences
Storing crypto on a self-custodial wallet gives people full ownership of their digital assets. With one of these digital wallets, people can freely send and receive multiple cryptocurrencies. Although all wallets serve the same purpose, there are distinctions in how they secure a user's crypto address.
In the crypto industry, there are two major wallet types: cold and hot wallet. While both of these wallets allow people to store cryptocurrencies, they work differently. Anyone thinking about buying crypto should understand the critical distinctions between a cold wallet versus hot wallet.
What are crypto wallets?
Wallets are as essential to crypto as coins and tokens like Bitcoin (BTC) and Ethereum (ETH). Without crypto wallets, people would have no way of using or storing digital currency. A crypto wallet provides investors with a reliable place to send, receive, and manage their crypto assets.
Since digital tokens live on decentralized blockchains, crypto wallets don't store cryptocurrencies directly. Instead, crypto wallets grant users a set of unique public and private keys that serve as an "address" on various blockchains.
Think of public keys as the address to your home and private keys as the literal key to your property. In crypto terms, the public keys help people send crypto to your blockchain address, but senders can't access your coins without the private keys.
Self-custodial wallets provide users with their private keys during setup. Usually listed in 12-24 word phrases (aka seed phrases), these private keys ensure users can recover their crypto even if their phone, laptop, or hardware wallet breaks. To recover crypto funds, you must input the private keys when setting up a new wallet.
Remember that the private keys give anyone access to the crypto in your wallet. For this reason, people must keep their private keys a secret if they use a self-custodial wallet. In contrast, custodial wallets don't provide users with their private keys. When using a custodial wallet, a third-party stores crypto on a person's behalf.
Centralized crypto exchanges (CEXs) offer custodial wallets to customers who keep their crypto on the trading platform. While cryptocurrency exchanges may offer insurance protections, they can freeze or seize users’ funds.
What’s a cold wallet?
A cold crypto wallet keeps a user's private keys offline. Since these private keys aren't connected to the internet 24/7, they're virtually impossible to hack unless somebody gets access to the wallet itself.
Paper wallets were an early form of cold wallets that involved printing a person's private keys on a physical piece of paper. Crypto users would have to scan the paper's QR code whenever they wanted to make a transaction. However, since it's easy to lose, rip, or smudge a piece of paper, these cold wallets aren't as prevalent nowadays.
There have been other variations of cold wallets over the years, but hardware wallets have become the top choice in the cryptocurrency industry. These USB-like devices connect with a user's computer or mobile phone. Some hardware wallets need a physical cord to connect to the internet, while others may have Bluetooth capabilities.
Using a hardware crypto wallet requires a unique PIN (personal identification number) to use a hardware crypto wallet. Nobody can use a hardware device without first entering the PIN. This extra step makes it more challenging for malicious actors to steal crypto from these devices.
Hardware wallets require users to sign every blockchain transaction by interacting with their physical devices. Once a user has successfully signed their transactions, they can safely unplug their hardware device.
Most high-profile crypto custodians like BitGo, Gemini, and Coinbase rely on cold storage crypto servers to protect their digital funds. While not the most convenient option, cold storage wallets provide the maximum security for crypto holders.
Currently, Ledger and Trezor are two of the crypto industry's most prominent hardware wallet manufacturers.
What’s a hot wallet?
Hot wallets are software applications that can store crypto directly on mobile or desktop devices. These wallets are "hot" because they're always plugged into the internet. It's easier for a hacker to trace private keys on a hot wallet because the private keys are online 24/7.
People typically download hot wallets from Google Play or the App Store like any other app for Android or iOS devices. Most of today's hot wallets are free to download, and some are available as mobile apps or browser-based extensions.
MetaMask, Trust Wallet, and Exodus are well-known examples of hot wallets.
Hot wallets vs. cold wallets
Choosing between hot wallets and cold wallets depends on how much an investor prioritizes safety over convenience. While hot wallets are highly intuitive, they can never match a high-quality hardware device's security. Since hot wallets are always online, there’ll always be a greater risk of a cyberattack than cold storage.
Although hot wallets are less secure than cold wallets, they’re easier to use in Web3 dApps (decentralized applications). People active on DeFi (decentralized finance) sites like Uniswap and Aave cab smoothly navigate Web3 with a hot wallet. Also, most NFT (non-fungible token) markets and play-to-earn games require users to link a hot wallet.
While some hardware wallets can connect with dApps, they’re deliberately more cumbersome to use. This feature is ideal from a security perspective, but it can be slightly challenging for some new crypto investors. People who want to make quick crypto transfers at a moment's notice can't be as spontaneous with a cold wallet.
Also, investors need to pay an additional amount for a hardware wallet. In most cases, people can download a hot wallet for free.
Generally, when investors refer to “cold wallet crypto,” they’re talking about large amounts of crypto they plan to hold as long-term investments. Since people don't intend to transfer these holdings for a few years, they’re comfortable with prioritizing security over convenience.
In contrast, those interested in using their crypto more frequently for short-term trades or in Web3 dApps tend to prefer hot wallets. While hot wallets aren't hack-proof, they’re far more user-friendly for trading crypto and interacting with Web3 protocols.
Remember that many crypto investors use both cold wallets and hot wallets. You can spread your crypto among multiple wallet addresses for different purposes.
How to choose a crypto wallet
With dozens of wallets to choose from, picking/choosing/deciding on one can be confusing for new crypto investors. If you're thinking about buying or downloading a crypto wallet, consider following these best practices:
- Wallet history and reputation: Ensure your wallet has a solid reputation in the crypto industry. Always stick with wallets that have years of experience in the industry with zero history of hacks, bugs, and exploits.
- Cryptos available on your wallet: Don't assume a cryptocurrency wallet will accept your preferred cryptocurrency. The way different wallet functions varies from blockchain to blockchain, so double-check the cryptos you're interested in are compatible with yours.
- Custodial vs. self-custodial: In the case of hot wallets, make sure the app will provide private keys. There are many custodial crypto wallets available for download. While there's nothing "wrong" with high-quality custodial wallets, remember that you won't enjoy the complete ownership of your crypto with these apps.
- Intuitive UI/UX: You must feel confident transferring the crypto to your app or hardware device. If you feel your crypto wallet is too complicated, research models with a more straightforward user interface.
How to securely use hot and cold wallets
Whether you decide to use a cold wallet, hot wallet, or both, these safety tips can help keep your crypto secure:
- Lock your private keys in a safe: Private keys are the most valuable feature in any crypto wallet. Carefully write down this list of words on a few pieces of paper and store them in a safe.
- Install two-factor authentication (2FA): Most hot wallets allow users to add an extra layer of security with either biometric login or 2FA. Installing these features helps make it more difficult for hackers to breach your account.
- Create dedicated wallets for airdrops or Web3 dApps: If you enjoy exploring Web3 opportunities like crypto airdrop rewards or liquidity pools, consider creating a separate wallet for these purposes. Since Web3 is prone to scams, storing any token rewards you get from dApps in one hot wallet is safer. Even if this wallet gets compromised, you won’t have to worry about losing all your crypto.
- Consider using a VPN: A VPN, or virtual private network, uses encryption technology to prevent hackers from invading your internet connection. Using a VPN will add additional security when reviewing sensitive data like your cryptocurrency portfolio.
You don't need to choose between a cold wallet vs. hot wallet. In fact, many investors spread their crypto across multiple wallet addresses. People often take advantage of software wallets when using Web3 dApps and put their long-term crypto investments in cold storage.
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