What are crypto wallets?

Golden Bitcoin token falling out of a wallet.

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Unlike traditional securities that are typically bought, sold and held through a brokerage house, cryptocurrencies allow investors to manage and transfer their assets completely peer-to-peer. For some, a major appeal of the digital asset ecosystem is the ability to hold assets without intermediaries such as banks and brokers. Unfortunately, this means that if you lose the seed phrase or private key of the wallet that holds your tokens – equivalent to passwords for online investment accounts – you will lose your crypto. There is no email recovery or customer support in the world of self-held cryptocurrency wallets.

Fortunately, there is a wide variety of wallet options that range from completely self-managed to completely outsourced. Digital asset holders should consider what is best for their personal situation. With options like cold storage (explained below), your personal security practices can be of great importance.

For those who are extremely risk averse, there are ways to gain exposure to cryptocurrencies through traditional financial markets that offer third-party custody, usually through a broker. These include futures contracts and exchange-traded funds that invest in them, over-the-counter trust, and publicly traded companies with crypto holdings or a dedicated business strategy in the industry, including MicroStrategyMSTR, an enterprise software company that continues to buy bitcoin; money transfer specialist Square; and miners Riot Blockchain and Marathon Digital.

For those who choose to keep their digital assets outside of the traditional financial arena, deciding what kind of wallet to use is a must. The main options are: preservative vs. non-preservative and hot vs. cold. Users must then select a specific wallet from those options. Each option offers trade-offs between ownership, ease of use, and security.

Custodian wallets

Custodian wallets are wallets held by someone on your behalf. If you keep assets on centralized exchanges such as Coinbase, Kraken, or Gemini, you must use a custodial wallet. Custodian wallets are by far the most convenient because accessing your crypto is like logging in for an online broker.

Custodial wallets may suit the average crypto investor whose digital assets make up a small percentage of a total portfolio. It also makes sense if you don’t rely on your ability to store crypto. Having a custodial wallet involves opening an account with a third party. You use a username, password, and typically a two-factor authentication system such as a personal identification number or a random authentication code. Users can also easily link a bank account to make instant purchases and verify their identity to increase spending limits or send and receive crypto. Instead of the share price, these portfolios show the number of digital assets and the value of the portfolio.

The biggest risk to custodial wallets is exchange hacks and the custodian becoming insolvent. Sophisticated exchanges typically keep most of their coins in cold storage, have versatile authentication measures, and use complex firewalls. However, this does not mean that they are immune to attack. In 2019, hackers stole $40 million worth of bitcoin in an orchestrated attack that used phishing scams and viruses against the popular Binance exchange. In addition, as seen with centralized financial lending platforms and exchanges such as CelsiusCEL, Voyager, and FTX, these institutions can freeze accounts and withdrawals if they face liquidity problems. Relying on third parties is easy, but comes with its own risks.

Non-custodial wallets

This category comes in two temperatures: hot and cold. Hot wallets are wallets that require an internet connection to access. They can be in desktop, web or mobile form. Cold wallets are not dependent on the internet. Cold wallets are physical devices that are almost impossible to compromise because they are not connected to the internet.

Hot Purses

Hot wallets are also known as software wallets.

Desktop wallets store a user’s private keys on the computer’s hard drive. Desktop wallets are relatively easy to use. Examples are Exodus Wallet and Atomic Wallet for multiple digital assets or Electrum and BitcoinbitcoinBTC Core specifically for the Bitcoin network.

Unfortunately, desktop wallets can be susceptible to malware. A trend with non-custodial wallets is that your assets are only as safe as your individual security practices – and people fall victim to phishing scams quite regularly. Between 2019 and 2020, hackers stole more than $22 million worth of bitcoin from Electrum wallets by sending users fake messages asking them to update their software. Once this happened, malware was installed and stole their money the next time they logged into their desktop wallet. Such occurrences can be avoided by keeping the official version of the software or only downloading updates from the official website.

Another kind of hot wallet is web-based. Web wallets include MetaMask, Phantom, and Trust Wallet. Coinbase also offers a version for users who prefer self-custody. These wallets do not store any private keys or personal information. They also allow users to sign transactions and interact with blockchain protocols. In addition, many popular decentralized applications have built integrations with these wallets to make it easy for users to access their crypto holdings when using them. For these reasons, they are the most popular type of non-custodial wallet. Like desktop wallets, they can also be victims of phishing and malware.

Cold wallets

Storing your digital assets offline starts with choosing a hardware wallet. The most popular manufacturers are Ledger and Trezor. While malicious actors have been known to try to steal crypto by tampering with hardware wallets, sometimes compromising their supply chains, offline storage is by far the most secure as there is no internet connection involved.

With cold wallets, your crypto is as safe as your personal security practices. Theft, loss, and physical destruction of the device need not mean a permanent loss of assets, as the seed phrase associated with a new device can be used to recover the funds on a new device. However, theft or loss of both the seed phrase and the device usually means that the assets cannot be recovered. If maintaining physical custody sounds stressful, a custodial wallet or desktop wallet might be an option to consider.

A common security approach is to rely on custodial or software wallets for digital assets that will be used in the foreseeable future and cold storage for long-term savings in a manner similar to checking and savings accounts at a bank.

Conclusion

Crypto wallet options are a lot like storing physical gold. Some people don’t rely on their own ability to keep the metal safe in a safe at home. They can forget the combination or a thief who found it written down can access the gold. To avoid such fear, this kind of person would outsource crypto storage to a third party and have a custodial wallet, although that carries the risk of government confiscation.

“Not your keys, not your coins” is a common refrain among digital asset enthusiasts who hate third-party custody; but let’s face it, the horror stories of people losing millions of dollars worth of bitcoin by misplacing their private keys are enough for anyone to question their ability to keep their tokens on their own.

Crypto owners need to know their priorities and limitations. For those who only have or want a small amount of exposure, some exchanges are heavily regulated and prioritize security. Dealing with private keys and cold wallets is not for everyone. At the same time, having all your eggs in one basket may not be the safest bet, especially if it involves a large portion of your net worth.

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