Understanding the Types of Wallets and their Differences
The main advantage of hot wallets is ease of use, as they are connected to the internet. You can use them to easily buy, sell, trade, and send cryptocurrencies. For this same reason, they are also less secure. Because they are actively connected to the internet, your private and public keys stored in the hot wallet are more vulnerable to online attacks. Hot wallets are typically software or web-base, existing on a company’s platform, a mobile wallet, or desktop wallets.
The main advantage of cold wallets is security, as they are NOT connected to the internet. Cold wallets are typically hardware-based (hardware wallets, USB drives, offline computers, etc.), meaning in order for a bad actor to access your keys they would need physical possession of the wallet, as well as the ability to bypass any password protections on the device. Consequently, this makes conducting a transaction with a cold wallet more difficult. Cold wallets must be turned on and connected to the internet in order to perform a transaction, and most require a user to then send their cryptocurrency to an exchange in order to trade. Cold wallets also must be purchased, while many hot wallets are free. Additionally, the risk of losing your physical cold wallet is greater than that of a software based hot wallet.
Hot vs Cold Wallets
A common analogy used to explain how one might decide how to use a hot or cold wallet is to look at them as similar to bank accounts; the hot wallet being associated with a checking account and a cold wallet being associated with a savings account. Most users would keep enough money in their checking account to use for day-to-day transactions, while storing large amounts of money in their savings account. If more money is needed in their checking account, they can transfer more over from their savings. Large crypto exchanges function in a similar fashion, in that enough cryptocurrency is kept in hot storage so that they have enough volume to provide for day-to-day transactions with their users, while large reserves are maintained in cold storage.
Public vs Private Keys
When conducting a cryptocurrency transaction, you will need both your public and private key. Public keys are used to identify you when you are receiving a cryptocurrency transaction (similar to providing your checking account/routing number to receive funds). These can be shared publicly without risk.
Private keys allow you to prove your ownership of the cryptocurrency and access it (similar to your login information to access your bank account). You should never share private keys with anyone, as they would then have access to all of the funds in the associated wallet and the ability to move it. Private keys are numerical codes, and you may never actually see it in full. For this reason, your cryptocurrency wallet will provide you with a “seed phrase”, which is a group of random words provided to you when you first set-up the wallet, and is used as an emergency backup if you lose access to your wallet. You must securely store this phrase exactly as provided, and like your private keys must not be given to anyone else.
Custodial vs Non-Custodial Wallets
The difference between custodial and non-custodial wallets comes down to who has control of your private keys. With a custodial wallet, a third party is in control of your private keys (typically a cryptocurrency exchange). You are trusting them with securely storing your cryptocurrency, and it is important that you research and decide to use a trustworthy exchange. The benefits of this is it requires less responsibility on your part, you can reset your password to the third party exchange if you lose it, and it is simpler and easier to use for beginners.
With a non-custodian wallet, you control your private keys and are responsible for keeping them secure. If you lose your private keys and seed phrase, it is impossible to recover your cryptocurrency. This type of wallet is typically preferred by experienced users, as they tend to allow more advanced functions and features than custodial wallets.