Summary: Understanding Crypto & Crypto Storage
A necessary feature of a robust cryptocurrency is its lack of intermediation. Blockchains, the infrastructures upon which cryptocurrencies exist, are peer-to-peer networks. This means there are no centralized intermediaries to rely on if you are wanting to control your own crypto. This is where cold storage for crypto has a significant benefit.
Sometimes, one leaves their crypto with an exchange like Coinbase, Crypto.com, or Binance. But when this happens, the user doesn’t actually control their crypto. The user only has a claim to the crypto that the exchange holds on their behalf. For many people, this is just fine. The big crypto exchanges are quite reliable and trustworthy custodians of crypto. However, for the user who wants to participate in the uncouth DeFi and metaverse opportunities the exchanges shy from, control over one’s cryptocurrency is required.
When storing and controlling cryptocurrency in your personal capacity, security of the storage mechanism becomes a consideration. The liberty afforded by peer-to-peer networks comes with responsibility.
“Cold” storage, “cold” hardware and “cold” wallets are all terms used to refer to the means of securing cryptocurrencies that are recognized as most secure. “Wallet” is the most popular nomenclature, so we shall proceed with that term.
The chilly descriptor, “cold”, implies the wallet is not “hot”. Cold wallets are not connected to the internet (offline), while “hot” wallets are (online).
To understand how and why a cryptocurrency secured with an offline cold wallet is safer than with one that is online and hot, we need to look at (i) what a cryptocurrency wallet really is, and (ii) what happens in an offline cold wallet vs an online hot wallet.
A Cryptocurrency Wallet
Cryptocurrencies are basically just databases that record the continual stream of entries made by users. Being a database, only, no cryptocurrency can really be “held” by someone’s wallet. The cryptocurrencies exist on the database and can’t really leave the database – they are just a database.
A wallet is a piece of software that holds two keys: a “private key” and a “public key”. A public key is used to create a public address on the database to which others can send cryptocurrency. After receiving cryptocurrency, your private key is used to send on that cryptocurrency to whomever you wish.
From the general user’s perspective, the wallet holding a private key is effectively the same as the wallet holding the cryptocurrency itself. But, when understanding the difference between “hot” and “cold” wallets, it is helpful to acknowledge that a wallet is key management, not cryptocurrency management.
Hot versus Cold Storage for Crypto
We know that making an entry to a cryptocurrency database is a recording of a user’s desire to send cryptocurrency to someone. This is a “transaction”. A transaction will only be accepted by the database if it has a valid “signature” stamped onto the transaction. The signature must come from the sender of the crypto. This is similar to a bank requiring a payor signature on a cheque before it is accepted for deposit.
To obtain the required signature, the sender’s wallet software uses the private key it holds to “sign” the transaction. The signed transaction is proposed to the database and, once verified by the database, accepted. Once accepted, it is recorded and the cryptocurrency is allocated to the recipient’s public cryptocurrency address (which would have been created from the public key found in the recipient’s wallet).
With hot wallets, the private key is used to create the signature on an internet-connected, online device, and the transaction executes as soon as the database accepts it.[1]
A cold wallet is an offline environment, meaning your private key is not connected to an internet-enabled device. This is why a cold wallet is often a physical device that can be separated from a computer, like a USB stick.
With a cold wallet device, the private key is hosted within the offline device. The private key within the device is used to sign the transaction, and the signing is done in a secure chip within the device that is not accessed by the online, hot device (the laptop). The signed transaction exists in a proposed, unexecuted state until the online hot device moves it to the internet.
In comparison, a hot wallet is where the private key is used to both propose and execute a transaction in an environment that is internet-connected. A cold wallet is where the transaction is proposed in an offline environment, but then executed in an internet-connected one.
Why use your private key to sign transactions in an offline environment?
Because this mitigates against the risk that your online device is infected with malware capable of recording and later using your private key to take your cryptocurrency.
What happens if you lose the cold wallet device?
Nothing terrible. When setting up your device, it would have presented you with a recovery phrase. It’s typically 12-24 words. This collection of words is a “seed phrase” and it is more important than the device itself. Efforts should be made to split the phrase and physically store the sections of the phrase in multiple physical locations. If you lose you cold wallet device, another device can be purchased. The 12-24 word recovery seed phrase is mathematically linked to the private key that controls your cryptocurrency. Inputting the recovery seed phrase in your new device restores that private key without requesting such information from any third party. This is the “cryptography” in cryptocurrency.
Should one use a cold wallet device?
It depends on you, the user. Very secure hot wallet software exists, but great malware exists, too. A hot wallet won’t be as secure as a cold wallet, but it may serve your purpose. The general rule is that one should secure the majority of their crypto via cold storage, leaving hot only those funds which one intends to trade frequently. As an example, a trader of crypto keeps about 10-20% in hot wallets – enough to capitalize on trading opportunities – and the remainder 80-90% in cold storage.
Best Crypto Storage Options on The Market
Interested in a safe and secure storage option for your crypto? Set up an account with Trezor, one of the safest options on the market for crypto storage for online or offline crypto storage. Trezor also has a desktop and browser app that makes managing your crypto easy and safe. Head over to Trezor to learn more!
In addition to Trezor, we highly recommend Ledger. Ledger provides a secure gateway to all of your crypto needs. You can buy, exchange and grow your crypto securely with a Ledger hardware wallet, combined with the Ledger Live app. Ledger is also launching a Crypto Life (CL) Card which you will be able to use at over 50,000 merchants worldwide as the CL Card functions like a VISA debit. Head over to Ledger to join the waitlist for your very own CL Card.
[1] Note: a hot wallet is different than cryptocurrency being held on an exchange like Coinbase, Crypto.com, or Binance. Exchanges hold onto the private keys controlling that crypto, not you. If you hold cryptocurrency on exchanges, you do not “have” the crypto, you only have a claim against the exchange for it.
