Hackers have stolen nearly $3 billion worth of cryptocurrencies from exchanges, decentralized finance (DeFi) protocols, and unsuspecting individuals since 2012. For example, millions of dollars worth of Bored Apes were recently stolen from browser-based wallets using hacked social media accounts and a spoofed website.
While some of these security incidents are preventable, many occur at the exchange or protocol level, leaving everyone vulnerable. The best way to protect against these threats is to move cryptocurrency from Internet-connected "hot wallets" to offline "cold wallets." However, managing hot and cold wallets can be a frustrating experience.
Let's explore the difference between hot and cold wallets and how to find the right balance for your crypto holdings.
Cold wallets are one of the most effective ways to reduce risk, but managing multiple wallets is difficult.
What Are Crypto Wallets?
Crypto wallets don't actually store cryptocurrency in the same way that a physical wallet holds dollars. Instead, your crypto holdings live on the blockchain under a specific address. However, you can only access these holdings with a private key. If you lose access to the private key (or someone steals it), you will lose access to your cryptocurrencies.
You have different private keys for different blockchains and wallet addresses. For example, Bitcoin private keys are 256-bit numbers. Only your private key can confirm the transaction when you initiate a blockchain transaction with a public key. But, of course, if someone steals your private key, they can make any transactions they want.
Crypto wallets keep your private keys safe. In some cases, that might mean encrypting and storing the private key data somewhere safe. In other cases, it might mean holding the private key and enabling you to make transactions via a crypto exchange or token bridge. In either case, they ensure you're the only one with access to the private key.
Hot Wallets for Convenience
Hot wallets have a direct connection to the Internet. For example, MetaMask is a hot wallet since it holds cryptocurrencies and tokens in your browser. Mobile and desktop wallets are more secure than browser-based wallets, but hackers still have access to them via the Internet. And there are plenty of examples of successful attacks.
Some examples of hot wallets include:
- MetaMask: MetaMask is a browser-based wallet that makes it easy to buy, sell, and trade cryptocurrencies and tokens. It's also a gateway to the broader Web3 ecosystem, making it ideal for those leveraging NFTs for authentication and other purposes.
- Trust Wallet: Binance's Trust Wallet is a mobile hot wallet featuring two-factor authentication and support for many crypto assets. Unlike many other wallets, you can purchase cryptocurrencies directly, making the wallet easier to use than other options.
- Coinbase Wallet: Coinbase's Coinbase Wallet is one of the most trusted options, providing a mobile wallet and a desktop option via a Chrome extension. Like the Coinbase exchange, the wallet is designed for ease of use but has fewer power-user features.
Of course, hot wallets are necessary to transact using crypto. For example, you need a hot wallet to send and receive cryptocurrencies and for Web3 authentication with non-fungible tokens (NFTs). By comparison, if you want to transact with a cold wallet, you need to connect it to the internet first, via Bluetooth or a USB and your computer.
Most exchanges provide hot wallet-like access to cryptocurrency but hold most funds in cold wallets. In addition, Coinbase and other businesses may have insurance policies against cyberattacks, protecting your funds in a security breach. However, these insurance policies may not kick in if someone tricks you into accessing your account.
Cold Wallets for Security
Cold wallets, also known as hardware wallets, is a physical device that stores your crypto assets offline. For example, Ledger wallets are devices that you plug into a computer when you need access to your cryptocurrencies or tokens. The only way attackers can steal from a hardware wallet is when they have physical access.
The most popular cold wallets include:
- Ledger: Ledger wallets are small USB devices that support a wide range of cryptocurrencies. Unlike many of its competitors, the device uses a Bluetooth connection to a smartphone app, making it convenient to access, while providing a Secure Element for enhanced safety.
- Trezor: Trezor wallets are similar to Ledger wallets. After setting your PIN and recovery seed, you plug in the device and have instant access. The devices also include a password manager and other features.
- Arculus: Arculus wallets consist of a credit card-shaped piece of metal that serves as triple-factor authentication for a smartphone app containing your crypto assets. Simply tap the card on your mobile device, and it shares the private key with the app.
The security of cold wallets comes with a significant risk of loss. For example, if you forget your PIN and backup codes, it may be impossible to recover cryptocurrencies or other assets on the device. In addition, if you lose or destroy the device, your crypto assets are gone forever. Therefore, it's vital to keep your device and backup codes safe.
A low-tech version of a cold wallet is a "paper wallet" that simply contains your private key. Some companies even make indestructible "paper wallets." For example, CryptoSteel capsules have adjustable separators to store your seed phrase and are nearly impossible to destroy, making them the safest option for storing crypto assets.
Hot Wallet Vs. Cold Wallet
More wallet choices
For beginners or users opting for a more hands-off approach, custodial wallets run by software providers could be a viable choice. Users are able to store their money on an exchange where it may be purchased or sold directly using these wallets. For assets maintained on their networks, several companies provide prizes or cryptocurrency interest.
The top three platform-based cryptocurrency storage options according to NerdWallet are Gemini, Crypto.com, and Coinbase. Exchanges keep a lot of cryptocurrencies, making these wallets simpler to access and recover, but hackers may find them particularly appealing because of this.
The Bottom Line
Most crypto investors, consumers, and enthusiasts use a combination of hot and cold wallets. For example, you may keep some cryptocurrency in an exchange for convenience but hold the bulk of your savings in a cold wallet. As a result, you can transact efficiently while keeping most of your assets safe from cyberattacks and other risks.
If you trade cryptocurrencies or other crypto assets, ZenLedger can help you aggregate your crypto transactions across wallets and exchanges, compute your capital gain or loss, and fill out the IRS forms that you need each year. We even provide an audit trail in the event that the IRS audits you, making it easy to rest assured everything is done right.