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Luis Clark
Luis is a personal finance expert who has been passionate and writing about crypto for more than five years.
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What is a Hot Wallet? How it Works and Security
Luis Clark
Luis is a personal finance expert who has been passionate and writing about crypto for more than five years.
Trading cryptocurrencies requires a cryptocurrency wallet to make crypto transactions. If you are thinking about getting started with cryptocurrency trading, then a crypto wallet is the first thing you will need.
A cryptocurrency wallet serves two major functions. First, they store all your private keys. This helps to keep your private keys organized in one place. The other function is to keep your keys safe from unauthorized users.
There are two types of crypto wallets: hot wallets and cold wallets. While both hot wallets and cold wallets have their advantages and disadvantages, we’ll primarily focus on hot wallets in this article.
What is a Hot Wallet?
A hot wallet is a basic type of digital wallet that is accessed through a website or application and is always connected to the internet and the relevant cryptocurrency network. It is also called a software wallet. Hot wallets store information about private keys and are usually accessed with a public key. The public key acts as a username, while private keys are used for signing a transaction linked to your public key.
How Does a Hot Wallet Work?
A hot wallet stores all your user-generated keys in a virtual space off the blockchain. In contrast, all your cryptocurrencies and tokens are stored on the blockchain. This is a good thing as it prevents anyone who has access to the blockchain record from getting hold of your private keys. Therefore, we can think of a hot wallet as a virtual purse filled with cryptocurrency keys. To use the hot wallet, the owner needs to access the blockchain with an internet connection and use the private keys within it to authorize crypto transactions.
Crypto hot wallets can store several types of cryptocurrencies, including the most popular ones like Bitcoin and Ether. As a general rule, they must be compatible with the blockchain of the network of your interest. For example, a Bitcoin wallet must be able to access the Bitcoin blockchain, and the Cardano Wallet must be able to access the Cardano blockchain platform.
The hot wallet must also be compatible with the current blockchain protocol. For instance, some legacy Bitcoin wallets may not be able to send Bitcoins to a SegWit wallet, although the reverse is possible. In the case of a hard fork, where a new blockchain is created from an existing one, a new wallet may be required, or the existing crypto wallet will need to be upgraded.
How Does a Hot Wallet Differ from a Cold Wallet?
Here is how hot and cold crypto wallets differ from each other:
Storage: A hot wallet works by keeping all your cryptocurrency funds on a cloud server. In contrast, a cold wallet stores your private keys on a physical device such as a USB flash drive. For this reason, a cold wallet is also referred to as a hardware wallet where your crypto assets are held in cold storage. A paper wallet has the same function.
Internet Connectivity: A hot wallet must always be connected to the internet to use. The service provider responsible for hosting the web server containing the wallet must also always ensure to keep it online. On the other hand, cold wallets are designed to store digital currency offline.
Types of Hot Wallets
Software hot wallets can be classified into different types based on different criteria.
Hardware
Mobile Wallets: A mobile wallet, as the term suggests, works as an app that is downloaded to a mobile device. Mobile wallets are usually developed and controlled by a third party and their UI is optimized for small touchscreen devices. They are light to use and are a good choice when connecting to cryptocurrency exchanges.
Web Wallets: Web Wallets are accessed through a web browser that connects to a specific website. You will still require a public key, or in some cases, an email ID or phone number to access the wallet. They are similar to mobile wallets but only differ in their mode of access.
Desktop wallets: Desktop wallets function as a cryptocurrency client and store transaction information on your desktop computer’s hard drive. Many of them are developed by first-party and community developers. They can download blocks from the blockchain directly to your computer. They are designed for powerful hardware, and offer advanced functionality like mining and bandwidth optimization. These wallets are recommended for advanced users.
Cryptocurrency
Single Asset: The most basic type of hot wallet only offers storing keys for one type of cryptocurrency. These types of wallets are rare these days and are limited to legacy wallets only.
Multi-Asset: Multi-asset wallets can hold many different digital currencies. They are ubiquitous, and almost all the major exchange or software hot wallets available these days belong to this class of wallets.
Utility
Standard Hot Wallets: A standard hot wallet can be used to store unlimited amounts of cryptocurrency funds. Using a standard wallet as the main wallet makes sense, especially if you want to keep your funds for the long term.
Mini Wallets: Mini wallets are usually connected to faucet apps that are designed to give small cryptocurrency rewards to users. Mini wallets only store a limited amount of cryptocurrencies, and in some cases, the funds need to be redeemed within a time limit. Once a mini wallet is full, it can no longer accept additional cryptocurrency and the owner will have to transfer the collected amounts to their main crypto wallet.
Control of Digital Assets
Custodial Wallets: Custodial hot wallets allow a third party to control private keys, and by extension, your digital assets. Users only have to give permission for transferring digital holdings when conducting cryptocurrency transactions. They are very convenient to use, as you can quickly recover your keys in case you lose access to them. However, these wallets run the risk of being breached, as you are giving up the responsibility of keeping your public and private keys secure.
Non-Custodial Wallets: Non-custodial wallets give full control of private keys to the user. Like their custodial counterparts, they come in different forms, including mobile and web-based apps. But their ultimate form is a hardware wallet. Keeping your assets secure is your own responsibility, and you must be careful not to lose your access details.
Hot Wallet vs. Cold Wallet: A Comparison
Hot and cold wallets have their own advantages and disadvantages. Here are some reasons to use a hot wallet over a cold wallet.
- Convenience: Hot wallets can be accessed from anywhere since they are always connected to the internet. All you need is an internet connection of course. Most of the options available can help organize your crypto assets to keep things easy and manageable. Easy access to your wallet also enables you to keep track of the amounts of your crypto assets. You won’t need to worry about keeping a physical device in a safe place or forgetting to bring one along with you for your trips. Once cold wallets get lost, so do your crypto funds – unless you kept the seed phrase secure to use your private key for another device.
- Flexibility: Software wallets are some of the most flexible digital wallets. Since almost any hot wallet can store multiple crypto assets, you can use one to frequently trade different cryptocurrencies. In fact, many cryptocurrency exchanges will provide you with a multi-currency wallet by default. On the other hand, a hardware wallet can become unusable if its firmware is bugged or if it breaks down.
- Compatibility: As technology advances, blockchain infrastructures and protocols need to be upgraded to keep pace with technical improvements. Your crypto hot wallet can be upgraded by the developer, allowing you to continue using it. Therefore, having a viable soft wallet keeps your crypto investments future-proof.
- No Cost: Many cryptocurrency wallets are free to use. Creating a free account is easy, and you do not have to risk any money on setting up a soft wallet. Hardware wallets cost money to buy, and some of them are not cheap, especially in countries where dollar exchange rates are high. Residents in some countries may not be able to buy cold wallets altogether.
Of course, there are some trade offs that you need to keep in mind when using digital wallets. These downsides make hot wallets a compelling alternative for storing your keys.
- Security: While a hot or cold wallet is usually safe, a cold wallet wins hands down in the security department. The main difference between the two is the physical layer of security that protects your crypto information that can be locked by closing an internet connection. With digital wallets, you risk losing access to your wallet if there is a breach or hacking attempt on your computer or on the third-party hosting service’s servers. Having a software wallet means that you will have to take extra security measures to keep your digital assets safe.
- Safe Backups: With a cold wallet, your digital currency moves with you. And you can access it when you are offline. If you manage your assets properly, you can ensure that you do not lose your digital assets.
Full Control: Your funds remain under your control in a cold wallet. This is important in case a cryptocurrency exchange or business you worked with defaults or blocks refunds and withdrawals. In case such an event happens to a hot wallet provider, getting back your funds may be a real hassle, if not impossible.
List of the Hottest Wallets in 2022
- Coinbase Wallet: Coinbase wallet is the premier wallet that supports hundreds of thousands of cryptocurrencies.
- Crypto.com DeFi Wallet: Supports over 800 digital assets, including DeFi coins
- Atomic Wallet: Atomic Wallet is one of the most favourable wallets for your digital assets out there. Atomic can be downloaded on a desktop computer or used on a mobile device. It allows users to manage, store, swap, send and receive hundreds of different cryptos and NFTs. It also has an integrated and easy-to-use staking feature, giving you the opportunity to earn interest on some of your crypto while being in possecion of your private keys.
- Exodus Crypto Wallet: A flexible wallet that supports multiple types of hardware devices and over 260 cryptocurrencies.
- Metamask: A very easy-to-use wallet that is trusted by over 30 million users worldwide. The first choice of newcomers in the Web3 space.
Hot and Cold Wallets: Which One is the Right Wallet for Me?
The right type of crypto wallet depends on your objective or experience with digital currency.
If you are new to the world of crypto and are in the market for a cryptocurrency wallet and want to store your public and private keys in a secure environment, then a hot wallet is a great option for you. It provides an easy entry point into the Web3 space, and comes with unmatched convenience.
Hot wallets also work best if you don’t like carrying too many physical USB drives when you travel. Since we’re already constantly connected to the internet, a hot crypto wallet is a no-brainer.
However, if you find yourself dealing with the security issues around software wallets, and want to keep more control over your digital holdings, then a cold crypto wallet might just be what you are looking for.
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