In 2019, the world of cryptocurrency investors and enthusiasts was taken aback. It was quite a shocking event for them when Binance, a well-known and trustworthy cryptocurrency exchange was hacked. They were stripped of 7,000 Bitcoins from its hot wallet amounting to a loss of USD 41 million. It compelled the shocked investors to take note of the vulnerability that hot wallets pose to cyber attacks.
In a similar incident, a few days ago, the Asian cryptocurrency exchange KuCoin also suffered a blow of USD 150 million. The hackers got hold of the private keys of KuCoin’s hot wallet. Again, it made the crypto world wary of hot wallet risks.
Such repeated failures of hot wallets gave rise to the debate of hot wallet vs cold wallet, especially from the perspective of security and safety. Two topics that YouHodler takes seriously.
So to help our community better understand and to delve deeper into this debate effectively, we must first examine what these two types of wallets are. A robust understanding of their features, functionalities, advantages, and drawbacks would equip us to compare them from the correct perspectives and in an appropriate context.
So, what is a hot wallet?
For people who trade in cryptocurrencies, there are no traditional financial services such as banks to keep your cryptocurrencies secure. Therefore, a cryptocurrency user can either use a hot wallet or a cold storage wallet to keep their crypto holdings safe.
A hot wallet is the most popular wallet among cryptocurrency traders to transact. It’s connected to the internet to facilitate real-time transactions. However, one needs to keep in mind that these wallets do not store anything. They are digital access points to your funds.
Many traders prefer hot wallets as it allows them to quickly trade funds. Whenever you log in to your wallet, you can start trading.
A cold storage wallet on the other hand doesn't have access to the internet. That’s part of the reason why they are so secure as it’s much harder to hack or comprise a wallet that’s not connected. Furthermore, this makes them a popular choice for crypto holders as they don’t require quick trading opportunities that hot wallets offer.
Do you know what's the most basic cold storage wallet? It's a paper wallet. Paper wallets contain public and private key details offline, and most importantly a QR code to authorize transactions offline. In paper wallets, the QR code is scanned before making a transaction.
There are other types of cold storage wallets as well. Hardware wallets that use a smartcard or an offline device to authorize transactions. We will discuss them further in the hot wallet vs cold wallet segment.
As you must’ve understood by now, the primary and the most basic difference between a hot wallet vs cold wallet is in their connection to an online server. While hot wallets remain connected to the internet at all times, a cold storage wallet is offline.
To make transactions using a cold storage wallet, one needs to initiate a transaction online. Next, they need to use an offline device such as a hardware wallet to validate and approve the transaction. Therefore, they have to sign the transaction offline using such a device before broadcasting the signed transaction to the internet. This process requires much more time and needs to be completed manually. Here, you own a public-private keypair and you are in full control of your funds.
In the hardware wallet version of cold storage wallets, offline USB devices or smart cards are used to generate these private keys. Whereas in paper wallet technology, public and private keys are printed through an offline printer.
In offline software wallets, the authentication process is split up into an online and an offline segment. The online segment holds the public key, while you use the offline part to securely generate the private key.
To summarize the differences, here are the key takeaways:
Why are cold storage wallets more secure? The answer is obvious! Under no condition, the private key of the cryptocurrency comes in any type of contact with a server. This makes it impossible for a hacker to intrude into the holdings of the investor, unless they can gain physical access to the device.
Even if a hacker manages to track a specific transaction, they can't hack into it without knowing the details of the private key.
Therefore, cold storage wallets are a must for holding cryptos without compromising their safety.
Now, the question that comes to mind is this: if hot wallets are so vulnerable to hacks, attacks, and intrusions, why do people still consider this as an option to store their holdings?
They do so because a hot wallet comes with a host of other advantages that make the life of a cryptocurrency user a lot easier and smoother.
One of the most significant advantages of hot wallets is that they are user-friendly. Completing a transaction through a hot wallet doesn’t require dabbling between offline and online environments. Remaining connected to the internet all the time also makes sure that an investor can initiate and complete their transaction quickly.
From a security perspective, although not as strong as cold storage wallets, hot wallets also provide multiple security options. Users can enable extra security features such as 2-factor authentication which has become the standard for securing cryptocurrency accounts via exchanges.
Despite having these many advantages, hot wallets often lose a lot of ground over the issues of security. The centralized servers used by hot wallets are always at the risk of getting hacked, skew the debate in favor of cold wallets. Moreover, these servers aren’t capable of handling high loads of transactions, making them prone to delays.
There is one other disadvantage of hot wallets that often goes overlooked. It’s that most of the time they do not provide access to the private key. Thus, hot wallets deprive investors of full control over their funds.
Needless to say, this is part of passing on the risks from the user to the exchange. Storing funds in a cold storage wallet also comes with some degree of risk. What if you lose the wallet? What if you lose the private key to access your wallet? This study shows that 20% of all BTC is lost unrecoverably.
Due to the high-security nature of cold storage wallets, it makes cold wallets a convincing winner in the hot wallet vs cold wallet duel. These wallets make sure that the private key of the crypto investor never gets exposed to the online environment in any way possible.
Paper wallets are also extremely cost-effective in the sense that it doesn’t require any offline device. For the price of €60, you can even buy a simple hardware wallet device to protect your funds.
Also, a cold wallet is not that cumbersome. Switching between offline and online environments to make a simple transaction sounds complicated. However, when seen against the ever-present threat of an investor losing all their holdings in case of a hot wallet, a little extra effort to run a cold wallet appears too small a tradeoff.
Does this mean that there are no drawbacks to cold wallets? Well, it also has a drawback. The owner of a cold wallet needs to be mindful of its susceptibility to physical damage. Therefore, they must use it with care and attention. Furthermore, you need to store the device in a safe location, such as a vault or secret location in your house.
It is quite evident that a cold wallet is a far more secure option than a hot wallet. There are some advantages of hot wallets when it comes to convenience and ease of use. But, when looking at the greater context of the increasing number of hacks - robust security is of paramount importance.
However, you can also adopt a hybrid strategy. For example, the majority of your cryptocurrencies you want to store long-term. Therefore, you opt for a cold storage wallet solution. On the other hand, you will use a small percentage of your funds for actively crypto trading. Here, you can opt to store those funds with an exchange using a hot wallet.
This hybrid storage strategy allows you to minimize your exposure to hot wallet risks. However, you’ll have to manage two different wallets to access all of your funds.
YouHodler would like to take this opportunity to show its high safety standards. Since June 24th, YouHodler uses Ledger Vault’s advanced custody and security options to store your cryptocurrency holdings safely. Read more about the Ledger Vault integration?