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Hot & Cold Wallet in Crypto

What is a wallet in the cryptocurrency industry? And what role does it play? As bankrate.com puts it, wallet is a service that allows cryptocurrency users to store and retrieve their digital assets. Similar to your personal wallets or bank lockers (hardware devices) where you keep your cash, credit cards, jewelry among other sensitive items. Not too long ago, investors were keeping their stock and bond certificates in a safe locker. With the rise of digitalization, especially since the start of the pandemic, we are now getting accustomed to online storage and transfer (via software) of such personal and sensitive materials.

Likewise in cryptocurrency space, there are primarily two types of wallets – Hot wallets and cold wallets. Hot wallets are those that are connected online or in other words, to the internet like software wallets. Cold wallets are those that are ‘disconnected’ from the internet which are typically hardware devices. You might wonder why someone would need a hardware or physical device to store digital assets? Keep reading 🙂

Cold Wallet

Hardware wallets are considered the safest among crypto wallets. They offer cold storage for your crypto assets since they are disconnected from the internet. ‘Ledger’ and ‘Trezor’ are the most widely used hardware wallets and they look similar to USB drives. You would connect your hardware wallets to the internet to transfer funds in and out of the wallet. Storage is offline but the data gets synced with the underlying Web 3.0 technologies like blockchain when you connect online to make transfers. For the most part, your digital assets will remain offline which has both advantages and disadvantages.

On the good side, you will not have to worry about online hacks and rug pulls (where the custodian runs away with your money). On the negative side, hardware devices are still vulnerable to physical thefts, natural calamities, loss of private keys and seed phrases or simple misplacings leading to  what happened to this man. As noted here in a blog post on Trezor’s website, as long as you have your seed phrase of a particular wallet safe, you can recover your cryptos using another wallet. It wouldn’t hurt to keep a few copies of the seed phrase on multiple devices or platforms provided they are not accessible to anyone else.

Hot Wallet

Hot wallets include your wallets on centralized and/or decentralized service providers. Wallets on crypto exchanges like Binance and Coinbase are examples of centralized hot wallets. Your demat account that holds your equity stocks can be considered as a centralized hot wallet. Further, wallets such as Metamask, Trust Wallet, Phantom are examples of decentralized wallet services. 

With decentralized services though, you are essentially the custodian of your own funds. One of the core objectives of cryptocurrency and Web 3.0 in general is to enable people to be their own banks without relying on third parties. No third party should be bothered about what you do with your funds as long as they are used for legitimate purposes. Those who are averse to centralized services (and cold wallets due to their disadvantages) have a good alternative in decentralized hot wallets which we will discuss below.

Centralized Hot Wallet

Centralized wallets require you to log in with a username and password, similar to how you log in to any other Web 2.0 application. This means your username/email address and password is stored on a centralized database. This information is authenticated by the platform that holds this data whenever you log in. You are then granted access to your funds. But as indicated in the above paragraphs, it all comes down to your choice.  Centralized platforms have the unilateral ability to withhold/restrict access to your own funds, suspend or terminate your account. Also funds sitting on centralized exchanges aren’t foolproof from hacking and social engineering threats.

Decentralized Hot Wallet

Decentralized open-source wallets, in contrast, have no central ownership of data and they can be accessed only by you. You typically won’t need username/password to login to a software based or browser based wallet. Instead you will get a Mnemonic phrase called a passphrase or seed key to access your wallet account.  It is a 12-24 readable word key and can serve both as an authenticator and a back up to access your wallet account. You will need something similar to username/password combo, though, to access various cryptos you own and store in the wallet. You can store most of your cryptocurrencies in one or more wallets. 

Each cryptocurrency you own will have a unique pair of public and private keys. Your public key (your public address, which works like an email address in Web 2.0) can be authenticated only by the corresponding private key (which works like a password). Public keys can be shared as you can imagine but private keys must remain private to you. Below tweet from Binance CEO, Changpeng Zhao, illustrates the growth and utility of open source wallet services.

Binance CEO CZ Wallet

They stay true to their functionality and grant access to anyone who holds the right keys to the correct wallet. Are open-source wallets 100% secure, though? Well, not quite. In the end, they are hot wallets connected to the internet. In rare cases, such as government sanctions or at the behest of local law enforcement, your account can be restricted for use or the access to it revoked. And since such solutions are online for the most part, they are vulnerable to malware attacks and other types of online frauds. 

 

Important things to note with your crypto wallets

  • Secure your seed phrases when using cold/hot wallets
  • Secure your private keys to a crypto’s public key
  • With any option(s) you choose, there is a trade off you have to make either with security or convenience/ease of use

To Conclude

Wallet service providers are definitely making  improvements to their products  with the evolution of  Web 3.0 space. They are also in the forefront of making wallets interoperable in the near future. Some of them are venturing into the space of password management for Web 3.0 as reported in this CoinDesk article. All said, I still hope to see an easy-to-use, fully decentralized, self-custodial, highly secure wallet sooner rather than later.

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Opinions expressed in this publication are those of the author(s). They do not necessarily purport to reflect the opinions or views of Shardeum foundation.

About the Author : Shriraam Sekar is a crypto writer/marketer involved in the space since 2019. He covers Layer 1s, DeFi, NFTs, Metaverse, GameFi, SocialFi, and crypto regulations. Follow him on Twitter for collaboration related to crypto/Web 3.0

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