What are Crypto Wallets? a guide

Unlike traditional securities that are typically bought, sold and held by 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 take custody of assets without the need for intermediaries such as banks and brokers. Unfortunately, this means that if you lose the seed phrase or private key to the wallet that holds your tokens – the equivalent of passwords to online investment accounts – you lose your crypto. There is no email recovery or customer support in the world of self-managed cryptocurrency wallets.

Fortunately, there are a wide variety of wallet options that run the gamut from fully in-house to fully outsourced. Digital asset holders should consider what is best for their personal situations. With options like cold storage (explained below), your personal security practices can matter a lot.

For the extremely risk-averse, there are ways to gain exposure to cryptocurrencies via 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 trusts and publicly traded companies with crypto holdings or a dedicated business strategy in the industry, including MicroStrategy MSTR, a business software company that continues to buy bitcoin; money transfer specialist Square; and miners Riot Blockchain and Marathon Digital.

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

Conservation wallets

Custodial wallets are those held by someone on your behalf. If you hold assets on centralized exchanges like Coinbase, Kraken, or Gemini, you should 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 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 random verification code. Users can also easily link a bank account to make instant purchases and verify one’s identity to increase spending limits or send and receive crypto. Instead of share price, these wallets show the number of digital assets held 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-layered 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. Furthermore, as seen with centralized finance lending platforms and exchanges such as Celsius CEL, Voyager and FTX, these institutions can freeze accounts and withdrawals if they experience liquidity issues. Relying on third parties is easy, but it brings its own set of 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 do not rely 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 a 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 multiple digital assets or Electrum and Bitcoin bitcoin BTC 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 frequently fall victim to phishing scams. Between 2019 and 2020, hackers stole more than $22 million worth of bitcoin from Electrum wallets by sending users fake messages telling them to update their software. When this was done, malware was installed that stole their money the next time they logged into their desktop wallets. Such occurrences can be avoided by keeping the official version of the software or only downloading updates from the official website.

Another type of hot wallet is web-based. Web wallets include MetaMask, Phantom and Trust Wallet. Coinbase also offers a version for users who prefer self-monitoring. These wallets do not store private keys or personal information. It also allows 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, it is the most popular type of non-custodial wallet. Like desktop wallets, they can also be subject to phishing scams and malware.

Cold wallets

Storing your digital assets offline starts with choosing a hardware wallet. The most popular manufacturers are Ledger and Trezor. While nefarious 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 only 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 can be used along with a new device to recover the funds on a new device. However, theft or loss of both seed phrase and device usually means that the assets are not recoverable. If maintaining physical custody sounds stressful, a custodial wallet or a desk wallet might be options to consider.

One common security approach is to rely on custodial 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.

Closure

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 could forget the combination or a thief who found it written down could gain access to the gold. To avoid such anxieties, this kind of person will outsource crypto storage to a third party and have a custodial wallet, although this carries the risk of government confiscation.

“Not your keys, not your coins” is a common refrain among digital-asset lovers who dislike 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 is enough for anyone to second guess their ability to keep their tokens themselves.

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, it may not be the safest to have all your eggs in one basket, especially if it involves a large portion of your net worth.

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