Hot vs Cold Wallet: Keeping Your Crypto Safe — AAX Academy
When you’re just getting started as an investor in cryptocurrencies such as Bitcoin, one of the things you need to think about is security.
As you know, cryptocurrencies are ‘digital assets’ — they exist only virtually with ownership recorded on a public ledger. A wallet is best compared to an email address whereas your private key is like a password.
But how exactly you will want to store your assets will depend on your intentions.
What is the difference between cold and hot wallets?
The simplest way to think about this is in terms of connectivity. A hot wallet is simply a way to store your cryptocurrencies online, with the benefit of easy access. The risk, of course, is that anything that’s online is more susceptible to hacks. The crucial thing here is that you will need to take extra care of keeping your personal information and password a secret.
A cold wallet is like a USB device. It has its own address on the blockchain and once you’ve transferred your funds, you disconnect the device from the internet. As you can imagine, this is a very safe method for storing cryptocurrency.
The downside of cold storage is that your funds are less easily accessible, which may be an issue if you are an active trader and want to be able to respond to opportunities quickly — even more so if you are a futures trading and you need to defend your position.
Why choose a hot wallet?
While cold storage could be a good solution if you’re looking to HODL — meaning, if you want to hold on your assets for a long time. In that case, cold storage may be for you. However, nowadays there are plenty of reasons to HODL online.
For example, more and more exchanges and DeFi-platforms offer savings products which allow you to earn interest on your assets.
If you’re interested in the DeFi space, a good hot wallet might be ‘MetaMask’. Keeping your funds in MetaMask allows you to browse the Internet and participate in all types of activities and trading schemes with your hot wallet as your central terminal.
You can also register with an exchange such as AAX. Keeping your funds with an exchange is essentially the same as keeping your funds in a hot wallet. But it’s not exactly the same.
When you hold your funds in, say, MetaMask, yoru funds are online and you yourself hold the key to those funds. When you hold your funds on an exchange, the exchange operators are also responsible for keeping your funds safe — not just you.
More importantly, while keeping your funds on exchange may come across as ‘keeping funds online’, such is not really the case. Usually, exchanges keep >90% of their funds in off-site cold storage facilities. As users trade on the platform, the exchange keeps track of what everyone owes, and if they were to want to withdraw their funds to another address (off-exchange), that’s when assets may be moved from the exchange’s cold vaults to the intended addresses.
Another benefit from keeping funds on exchange, is that the exchange can help, compensate or pursue matters in case of a security breach. If your funds get lost while trading on some DeFi platform or in a peer-to-peer setting (with some stranger on Facebook), there is no recourse.
Decentralization is key
The main argument against keeping funds on an exchange is actually more a matter of principle than it is necessarily about security — the principle being ownership. Of course, there is no denying that exchanges have been hacked — wherever there is money, there will be those who might want to take it.
If you are a secret Bitcoin millionaire, cold storage might indeed be the best option for you. But that only makes sense if you see your crypto as a long-term store of value or if you expect the value of your assets to increase significantly over time. Generally, making money with crypto will require some buying and selling at appropriate moments.
In this sense, perhaps the best way is to distribute your funds. Keeping your funds on an exchange means you can get easy exposure and are able to benefit from extra services such as savings. Be sure to get a better understanding of how the exchange approaches security.
You might want to hold a portion in a hot wallet of your own, allowing you to scour the internet and experiment.
If you have a surplus that you do not necessarily want to leave online but rather keep as an insurance against some future financial apocalypse (or revolution) then cold storage might be a good option for you.
Originally published at https://academy.aax.com on October 22, 2020.