Hot Wallet vs Cold Wallet: What’s the Difference?

Cryptocurrency has exploded in popularity, and with it so has the variety of cryptocurrency wallets on the market. Dozens, if not hundreds, of new wallets have appeared over the last few years, making it difficult for cryptocurrency holders to choose which one is right for them. 

This article will break down the most common wallet types and their advantages and disadvantages to help you gain a better understanding of the technology and make an informed decision about how to protect your digital wealth. 

What is a Wallet?

A wallet is shorthand for the data which allows you to send, receive, and store cryptocurrency. 

In its most basic form, a wallet consists of two strings of numbers and letters— a public key, and a private key. You could say the public key is like an email address, and the private key is like a password. It’s a bit more complicated than that, but unless you feel like taking a technical deep dive, we can leave it at that for now. 

In order to send Bitcoin or any other cryptocurrency, it’s necessary to “sign” a transaction with the private key. This signature makes it possible for the network to know that you are the owner of the address, without requiring you to reveal your private key. 

Many wallets also contain additional features like ways to view your transaction history, features for managing transaction fees, the ability to sign and send transactions, and tools for managing addresses.

Custodial vs. Non-Custodial Wallets

All wallets can be classified as either custodial or non-custodial. 

In short, a non-custodial wallet means you are fully in control of your private key, and no one has “custody” of your coins. This means you have more power (no chance of your account getting frozen due to bogus fraud alerts!) but you also have the responsibility to secure your money. 

A custodial wallet, on the other hand, means you trust someone else to secure your key(s). Custodial wallets from reputable websites are generally secure and easy to use, but many cryptocurrency users dislike them for various reasons. One of the most common is fears about hacks or possible changes in regulation which could lead to funds being frozen or seized by the government.

A number of cryptocurrency exchanges have fallen victim to hacks, in some cases resulting in huge losses for their customers. Security standards are getting better, but many people would still rather hold their own keys.

Government seizure may seem unlikely, but some cryptocurrency enthusiasts point to multiple historic instances where governments forcibly seized gold from their citizens. Hopefully nothing like that will happen again, but many people are attracted to cryptocurrency because they believe it will be more resistant to seizure by corrupt or tyrannical governments.

People with these kinds of concerns are willing to put in the effort to secure their cryptocurrency themselves and opt for non-custodial wallets, while others are willing to trust a reputable third party.

Seed Phrases

If you use a non-custodial wallet, in many cases you will be given a seed phrase. Seed phrases are algorithmically generated strings of 12 to 24 words which can be used to recover your keys if your wallet is lost or destroyed. Since they consist of commonly used words, they are easier to work with than a long string of numbers and letters.

A popular way of backing up a wallet is to engrave the words of the seed phrase onto a metal plate. This can be stored in a secure place, and can survive fires, floods, or other events which could damage a paper seed phrase.

Related: 8 Signs that Bitcoin is Going Mainstream

Hot Wallets vs. Cold Wallets

A hot wallet refers to any kind of wallet stored on a device connected to the internet. This could be a mobile wallet, desktop wallet, a wallet based in your browser, or a wallet belonging to an online service or website. 

Cold wallet refers to any wallet which has no direct connection to the internet. Cold wallets are generally seen as being higher security, since it is impossible for hackers to gain access to them digitally.

Hot wallets may be custodial or non-custodial, but all cold wallets are non-custodial. Hot wallets are almost always more convenient than cold wallets, but they are usually not recommended for storing large sums of cryptocurrency because of the risk of a hack.

Following is a breakdown of the most common types of hot and cold wallets.

Hot Wallets

Desktop Wallets

Desktop wallets were the first type of functional cryptocurrency wallet to be developed. They store public and private keys on a computer’s hard drive, and usually include a graphical interface for sending and receiving cryptocurrency. 

A number of desktop wallets are available for various currencies on Windows, MacOS, and Linux operating systems. Most desktop wallets are non-custodial.

Browser Extension Wallets

A browser extension wallet is a wallet built into a web browser. These are generally used for interacting with decentralized web apps, most notably those using Ethereum. 

The most well-known browser extension wallet is MetaMask, which provides a convenient way to send and receive Ethereum to and from decentralized applications like NFT marketplaces or monetized online games. Browser extension wallets are usually non-custodial, meaning you have to keep track of a seed phrase to recover your funds in case you somehow lose your keys.

Web Wallets

Web wallets are usually web based services that provide cryptocurrency custody services to their users. A web wallet is typically accessed through a website. In most cases, you don’t actually have direct control over a web wallet, and you have to trust the web wallet provider to keep your coins safe. 

This has some advantages, because it means you don’t have to manage your own security, but cryptocurrency purists generally look down on web wallets because of the long history of users losing funds from them. In some cases these losses have been due to hacks. In other cases, those entrusted with funds just disappear with user funds.

This is less likely to happen with more reputable companies, but due to these risks, most cryptocurrency avoid keeping large sums in web wallets. Another risk with web wallets is the possibility of funds being frozen for various reasons, like having a name similar to someone on a sanctions list, or transaction activity getting flagged as suspicious.

The most common type of web wallet is an exchange wallet, where funds can be stored while trading one cryptocurrency for another. If you've bought any Bitcoin on sites like Coinbase.com, this is considered a web wallet. Exchange wallets are usually custodial, meaning your balance is stored on the server of a centralized exchange, but in the case of decentralized exchanges, your keys may also be stored on your computer although you access the wallet through your browser.

Most web wallets are custodial, but there are a few that offer hybrid solutions to maximize both security and convenience.

Hybrid Wallets

Hybrid wallets split the data required to access funds between a web service and a device controlled by you. This means that to send a transaction, you access a web service, much like any web wallet, but the service itself has no control over your funds. 

This way, only you have the ability to make a withdrawal. By this method, hybrid wallets achieve a higher level of convenience without many of the risks typically associated with web wallets.

Mobile Wallets

Mobile wallets refer to any wallet stored on an Android or Apple smartphone. They are more or less identical to desktop wallets, but are more convenient for sending transactions on the go. 

For example, most mobile wallets have QR code scanners built in, so you can send funds to a friend easily by scanning his address with your phone’s camera.

Cold Wallets

Paper Wallets

Paper wallets are the most rudimentary kind of cryptocurrency wallet. They are composed of little more than a public address and a private key written on a piece of paper. 

Though paper wallets are simple, they are a highly secure form of cold storage. They are not convenient at all, however, and you need to be very careful when uploading your private key to a device in order to send a transaction.

It goes without saying that paper wallets are vulnerable to house fires or water damage.

Brain Wallets

Brain wallets are similar to a paper wallet, except that the data is stored in your brain. This can be very difficult with an ordinary private key, so most brain wallets consist of unique, complex pass phrases which are used to algorithmically generate the wallet’s private key and public address. Another possibility is to memorize a seed phrase and then delete or destroy the associated wallet.

Brain wallets are even more inconvenient than paper wallets, because you have to first convert your passphrase into the address and private key, and then use it to send transactions the same way you would with a paper wallet. Brain wallets offer great security against theft, though, because they exist purely in your mind.

There are some risks associated with this, of course. A head injury could cause you to forget your passphrase, or unexpected death could deprive your heirs of their inheritance. For these reasons, the use of brain wallets is relatively rare.

Hardware Wallets

Hardware wallets are one of the most popular wallet solutions because they offer a good balance of convenience and security. Private keys are stored completely offline in a dedicated device with built-in security features. 

When you want to access the funds stored on your addresses, you connect the device to a computer and use it to sign and broadcast a transaction. Even if your computer is compromised, hackers will have no ability to access your private keys. 

An ever growing list of companies are competing in the hardware wallet market. Ledger and Trezor are two of the most popular. 

Note: when buying a hardware wallet, it’s important to thoroughly verify the authenticity of the wallet, because some scammers will sell fake hardware wallets designed to steal people’s funds. 

Multi-signature Wallets

If you’re worried about keeping “all of your eggs in one basket,” multi-signature wallets might be a good option. Multi-signature wallets require multiple people to sign a transaction in order to send it. 

For example, a wallet can be generated with 3 keys, and require at least 2 of them to send a transaction. This way, a family or business can distribute the responsibility of securing funds between multiple people. If one person loses their keys, the others can still recover the wallet. 

Both cold and hot wallets can be set up to support multi-signature configurations.

Related: Crypto IRA Guide: How to Buy Cryptocurrencies with Your 401(k)

Choosing the Right Wallet

With all of these wallet options, there is a clear trade off between convenience and security— the more convenient, the less secure. 

Many people choose to distribute their funds between multiple types of wallets. For example, they use mobile or desktop wallets to store a small amount of funds for everyday use, while the bulk of their cryptocurrency is kept in a paper or hardware wallet.

Hardware wallets have emerged as one of the most popular options because of their balance of security and convenience, but their main drawback is expense. Depending on the amount of features you want, a typical hardware wallet could cost anywhere between $50 to $200 USD. 

You can achieve a similar level of security and convenience on your own, but it will probably require investing more time into learning the ins and outs of the software. In any case, the best way to learn about wallets is to dive into using them. 

Start with small amounts of cryptocurrency, and send funds back and forth between different kinds of wallets. In this way, you can get a feel for what works best for you.