What is a crypto wallet? Securing your digital assets

Ever since the advent of physical currency more than two millennia ago, people have used purses and wallets to store their money and other essential items. In the crypto world, wallets serve a similar function but with added complexity that helps keep digital assets secure.

Crypto coin wallets store private keys, which are necessary for all crypto transactions. But there are important “hot and cold” distinctions among the different types. 

In this guide, we’ll explore what crypto wallets are, how they work, and the differences between hot and cold wallets. We’ll also explain how to choose a crypto wallet that suits your needs and trading habits.

Understanding crypto wallets

Crypto wallets are software applications used on computers or mobile devices like phones or tablets. They do not store the crypto assets themselves; instead, they manage the private keys needed to access and interact with the blockchain network for various cryptocurrencies. These private keys are cryptographic codes crucial for users to securely access and manage their digital funds on the blockchain.

Hot (digital) versus cold (hardware) wallets

Crypto wallets are generally classified into two types: hot and cold. Hot wallets are digital and keep private keys on a device connected to the internet, providing easy access but with a higher risk of online threats. Cold wallets, on the other hand, are physical devices that keep private keys offline, offering enhanced security against hacking and malware.

Hot wallets can be custodial or noncustodial. Custodial hot wallets are managed by a third party that holds the private keys, whereas noncustodial hot wallets allow users to retain full control over their private keys, providing greater security and autonomy. These wallets often use QR codes to facilitate transactions.

Cold wallets are typically noncustodial, giving users full control over their private keys. Among cold wallets, hardware wallets are a specific type that stores private keys on a physical device, adding an extra layer of protection, making them a preferred choice for those seeking maximum security.

Different types of crypto wallets offer various advanced features, such as multi-signature (multi-sig) for enhanced security. Regardless of the type, crypto wallets generally allow users to:

• Send and receive crypto assets
• Monitor their crypto asset balance
• Interact with decentralized applications (dApps)

How to choose a crypto wallet

Choosing the right crypto wallet depends on your specific needs. For frequent traders, hot wallets provided by reputable exchanges offer convenience, while noncustodial or hardware wallets are often preferred for long-term storage due to their enhanced security.

Key factors to consider when choosing a crypto wallet include:

Security

Storing cryptocurrency without proper security is like leaving a wallet in a busy public place – exposed to potential theft. For storing significant amounts of cryptocurrency, many users opt for cold or noncustodial wallets. The most secure wallets should include:

• Strong encryption: Advanced encryption algorithms, such as AES-256, to protect private keys and transaction data
• Two-factor authentication (2FA): An additional layer of security, like a code from a mobile app, on top of a password
• Biometric security: Optional biometric verification, such as fingerprint or facial recognition, for added protection

Reputation

Choosing a wallet provider with a history of security breaches can increase the risk of asset loss. It’s important to consult reviews and utilize security audit services like Hacken to assess a crypto wallet's reliability and track record.

Fee customization

Some wallets allow users to customize transaction fees, providing flexibility to prioritize either speed or cost efficiency. For example, on the Ethereum network, users might choose a higher fee for a faster transaction or a lower fee if speed is less of a concern.

Multisignature (multisig)

Multisig wallets require multiple keys to authorize a transaction, reducing the risk associated with a single point of failure. This feature is valuable for both individual users who seek enhanced security and organizations needing consensus for transactions.

How to set up hot and cold wallets

Setting up a crypto wallet is not a one-size-fits-all process. Hot (digital) wallets are convenient for daily transactions because they're accessible from any internet-connected device and are often developed by reputable cryptocurrency exchanges like Coinbase. However, because they are always online, they are more vulnerable to cyberattacks.

In contrast, cold (hardware) wallets require additional steps, such as connecting to a computer via USB, but they offer enhanced security by keeping private keys offline, thus preventing remote access by hackers. Many traders prefer cold wallets for long-term storage of their assets.

Hot (digital) wallets

1. Install the wallet app: Download a trusted wallet app, such as Coinbase Wallet or MetaMask.
2. Create a new wallet: Follow the prompts to create a new wallet and set a strong password or PIN.
3. Secure the recovery phrase: Write it down and store it in a safe place, ideally offline and away from any potential security threats. This phrase is essential for restoring wallet access if lost. Make sure to never share your recovery phrase with anyone, as it will grant them full access to your wallet.

Cold (hardware) wallets

1. Purchase a hardware wallet: Buy a reputable hardware wallet, such as Ledger or Trezor, directly from the manufacturer or an authorized reseller. Buying directly from the manufacturer reduces the risk of purchasing a device that has been tampered with.
2. Download hardware wallet software: Download the companion software from the official website.
3. Connect the hardware wallet via USB: Plug the hardware wallet into a computer using a USB connection.
4. Choose a PIN: Set a secure PIN to protect the device from unauthorized access.
5. Secure the recovery phrase: Write down the recovery phrase provided by the hardware wallet and store it in a safe place, also away from any potential security threats.

Weighing the pros and cons of crypto wallets

Like any technology, crypto wallets have both strengths and weaknesses. When selecting a wallet – whether hot, cold, custodial, or noncustodial – consider the following factors:

Advantages

• Self-ownership of money: Crypto wallets provide users with complete control over their funds, eliminating the need for third-party intermediaries. This decentralization ensures that only the wallet holder has access to the private keys and the associated crypto assets.
• Freedom of transactions: Users can send and receive funds globally without requiring permission from centralized banks or financial institutions. Noncustodial wallets, in particular, offer total control over funds, enabling greater economic freedom and the ability to transact directly with others, regardless of geographic location or social standing.

Disadvantages

• User responsibility: Managing private keys and maintaining security is the sole responsibility of the user. If private keys are lost, compromised, or corrupted, there is no way to recover the assets. This level of responsibility can be daunting, especially for beginners, and the potential loss of a hardware wallet adds to the concern.
• Learning curve: New users may find it challenging to learn how to use crypto wallets effectively and securely. The need to understand different wallet types, security practices, and transaction procedures can be a barrier to entry for many.

The evolution of financial freedom and crypto wallets

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Also, visit our official blog for beginner-friendly guides on topics like Bitcoin halving, how to earn tax-free Bitcoin, tips for accounting professionals, and more.

Disclaimer: This post is informational only and is not intended as tax advice. For tax advice, please consult a tax professional.