What are crypto wallets?

Unlike traditional securities that are usually 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 attraction of the digital asset ecosystem is the ability to care for assets without the need for intermediaries such as banks and brokers. Unfortunately, that means that if you lose the passphrase or private key to the wallet containing your tokens—the equivalent of passwords for online investment accounts—you lose your crypto. There is no email recovery or customer support in the world of self-service cryptocurrency wallets.

Fortunately, there are a wide variety of wallet options that run the gamut from fully self-managed to fully outsourced. Holders of digital assets should consider what is best for their personal situation. With options like cold storage (explained below), your personal security practices can make a big difference.

For the extremely risk-averse, there are ways to gain exposure to cryptocurrencies via traditional financial markets that provide third-party custody, usually through a broker. These include futures contracts and exchange-traded funds that invest in them, over-the-counter trusts and listed companies with crypto holdings or a dedicated business strategy in the industry, including MicroStrategy, a business 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 the traditional financial arena, deciding what kind of wallet to use is a must. The main options are: storage versus non-storage and hot versus cold. Users must then select a specific wallet from these options. Each option presents trade-offs between ownership, ease of use and security.

Storage wallets

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

Custodial wallets may be appropriate for the average crypto investor whose digital assets make up a small percentage of an overall portfolio. It also makes sense if you don’t trust your ability to store crypto. Having a custodial wallet means opening an account with a third party. You use a username, password and usually a two-tier verification system such as a personal identification number or randomized 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 stock prices, these wallets show the number of digital assets and the portfolio value.

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

Non-custodial wallets

This category comes in two temperatures: hot and cold. Hot wallets are those 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 Wallets

Hot wallets are sometimes referred to as software wallets.

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

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

Another type of hot wallet is online. Online wallets include MetaMask, Phantom and Trust Wallet. Coinbase also offers a version for users who prefer self-storage. These wallets do not store private keys or personal information. They also allow users to sign transactions and interact with blockchain protocols. Additionally, 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 vulnerable to phishing scams and malware.

Cold wallets

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

With cold wallets, your crypto is as secure 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 combined with a new device can be used to restore the funds on a new device. However, theft or loss of both the seed and the device usually means that the assets cannot be recovered. If maintaining physical custody sounds stressful, perhaps a custody wallet or stationary wallet are options to consider.

A common security approach is to rely on escrow or software wallets for digital assets that will be used in the near 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 much like storing physical gold. Some people do not trust their own ability to keep the metal safe in a safe at home. They may forget the combination or a thief who found it written down could gain access to the gold. To avoid such anxiety, this type of person would outsource crypto storage to a third party and have a custodial wallet, even if it carries the risk of confiscation by the authorities.

“Not your keys, not your coins” is a common refrain among digital asset aficionados who resent third-party custody; but let’s be honest, the horror stories of people losing millions of dollars worth of bitcoin by misplacing their private keys are enough to make anyone second guess their ability to care for the tokens themselves.

Crypto owners should know their priorities and limitations. For those who only have or want a small exposure, some exchanges are highly regulated and prioritize safety. 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 option, especially if it involves a large portion of your net worth.